Purchasers of public companies focus on negotiating the best terms for the acquisition. Price, break-up fees, deal protections (such as voting agreements or matching rights), closing conditions and required actions to facilitate regulatory approval or obtain financing all are key deal considerations for buyers. However, absent special situations, including controlling stockholder transactions or management-led buyouts, the process followed by the acquired company typically receives little attention from buyers. Indeed, buyers typically seek to preempt a competitive bidding process, obtain exclusive negotiating rights or otherwise become the "preferred" bidder. Recent cases focusing on conflicts of interest involving those negotiating on behalf of the acquired public company and of its advisors suggest that potential buyers have an interest in ensuring that the sales process withstands stockholder allegations that the sales price or other transaction terms were the product of a tainted process in which the interests of the acquired company's stockholders were subordinated to those of management, a large stockholder or the acquirer. The buyer's interests include the ultimate acquisition costs after taking into account litigation and possible settlement expenses, avoiding uncertainty or delay in closing because of injunctive or other judicial relief, and avoiding liability for aiding and abetting breaches of the fiduciary duties of the directors and officers of the acquired company. In this memorandum we will summarize the key conflict and other sales process issues identified by Delaware courts in three recent cases, examine the risks and potential liabilities that these issues can create for buyers, and finally suggest some steps buyers can take to avoid or mitigate these risks.
Recent Developments
In the last six months the Delaware Chancery Court has handed down three opinions in shareholder derivative actions, all highly critical of the process undertaken by the target companies (and their advisors) in agreeing to sell their respective companies. In Southern Peru,1 a derivative action challenging Southern Peru Copper Corporation's acquisition of Minera Mexico in circumstances where a controlling stockholder stood on both sides of the transaction, the court criticized the Southern Peru special committee for its failure to explore alternatives, questioned its approach in directing the valuation strategies used by its financial advisor, and ultimately concluded that both the sale process and the price paid were unfair. The court awarded over $1.26 billion in damages to the shareholders of Southern Peru payable by the controlling stockholder, an amount intended to represent the difference between the deal consideration and the court's estimate of the price that would have been paid in an entirely fair transaction. As noted this case involved a stockholder that controlled both the buying company and the company sold to the buyer; the stockholder was, accordingly, subject to an obligation to pay a fair price pursuant to a fair process. However, the court's criticism of the valuation methodologies employed by the special committee's financial advisor and the personal interests of certain committee members in completing a transaction for reasons other than price provide warnings for transactions outside of the entire fairness arena.
In reviewing the pending acquisition of El Paso Corp. by Kinder Morgan Inc. in El Paso,2 the court once again took the target board to task for its "many questionable tactical decisions", most notably its acquiescence to Kinder Morgan's threat to go hostile and the subsequent reduction in its offer price, and the use of its CEO as lead negotiator in circumstances in which the CEO, unbeknownst to the rest of the El Paso board, had an intention to pursue a post-transaction purchase of one of El Paso's divisions from Kinder Morgan in a management buyout. The court found El Paso's less-than-aggressive negotiating strategy, including the failure to perform even a soft pre-signing market check, particularly troubling given the concealed self-interest of its CEO and its ineffectiveness in walling off the conflicting incentives of its financial advisor, who held a significant stake in Kinder Morgan and also had two designees serving on Kinder Morgan's board. In light of the CEO's purported interest in purchasing assets from the buyer, the court found a reasonable likelihood that he failed to negotiate for the highest possible sales price in order to avoid antagonizing Kinder Morgan and remaining a preferred buyer for the El Paso division, as well as not increasing the valuation of the division he desired. Rather than enjoining the transaction and depriving El Paso stockholders of the opportunity to approve a premium sale in a situation in which no competing bids appeared, the court held that damages claims against the El Paso CEO were an available, if imperfect, remedy.3 Chancellor Strine went on to say that it was doubtful whether plaintiffs could prove a separate aiding and abetting claim against El Paso's financial advisor, but that after-the-fact damages claims do have some remedial value and the prospect of a damages trial is no doubt unpleasant to the financial advisor.
The Delaware Chancery Court also refused to enjoin a sale of a public company at a substantial premium when no competing bids had surfaced in Delphi.4 In a March 6 opinion, Vice-Chancellor Glasscock found a reasonable likelihood that a controlling stockholder had improperly demanded and obtained a higher price for his super-voting stock than that payable to the public stockholders even though the target company's charter required that all stockholders receive the same consideration in a merger. The controlling stockholder emphasized that he would not sell to a third party without a premium for his shares and pressed for a charter amendment deleting the restrictive provision. Finding that a post-closing damage remedy was preferable to preventing stockholders from voting upon a sale at an attractive price with full disclosure of the potentially flawed sale process, the court indicated that neither the independent directors of the target nor the buyer were subject to any claims of misconduct. Interestingly, the court upheld the claims against the controlling stockholder in a situation in which an unconflicted special committee (which in turn formed a sub-committee), with an unconflicted financial advisor, robustly negotiated with the controlling stockholder as to whether and how much of a premium he should receive over the price paid to public stockholders and the transaction was subject to approval by a majority of the disinterested shares. In the context of a pending sale, the court found that the controlling stockholder, who took the lead in negotiations with the buyer, violated either fiduciary or implied contractual good faith obligations in conditioning his approval of the merger on a repeal of a charter provision requiring that all stockholders be treated equally.
Why Buyers Should Care
Much has been written about what these decisions mean for sellers and the principles that should guide the behavior of target boards and their advisers in future transactions. After all, the opinions of the courts are focused on the practices that selling company boards and their advisors should follow and the ways in which conflicts should be dealt with. In a real sense, much of the court's opinions are prescriptive guidance for the next deal.
However, what of the buyer? Can buyers take comfort in the current inclination of the Delaware Chancery Court not to enjoin sales at premium prices to unrelated third parties? What exposure, if any, does a buyer take on in the context of an acquisition where the sale process was (or is alleged by plaintiffs' attorneys to be) tainted? What can buyers do to mitigate the risks associated with these acquisitions?
- The most common burden confronting buyers is the financial cost
associated with defending and, if a dismissal is not forthcoming,
settling the litigation. Studies have found that over 90% of recent
M&A transactions valued over $100 million elicit class action
or derivative suits attacking the transaction terms or the adequacy
of the disclosures and/or accusing the target board of directors of
misconduct.5 While in most cases only the seller and its
directors (and not buyer) are named as defendants, in all cases
both the target and buyer alike are aligned in their mutual desire
for a quick resolution of the suit and consummation of the pending
transaction. To that end both parties will expend significant time
and resources rebutting plaintiffs' allegations in pursuit of a
settlement or dismissal. The buyer is likely to incur considerable
costs as part of this effort, which can continue even after the
transaction has closed. These costs can be minimized if the factual
issues raised by alleged conflicts or other deficiencies in a sales
process are avoided so that litigation may be resolved quickly upon
a motion to dismiss or for summary judgment.
In addition to the defense costs, there are typically two other monetary components associated with any settlement or other disposition of these derivative suits. First is the amount of any plaintiffs' attorney fees included in the settlement or court order, which on average have totaled approximately $1.2 million.6 The defendants may also be obligated to pay damages to the aggrieved shareholders. Although only a relatively small percentage of cases result in payments to shareholders, the payments are sometimes quite substantial7 and typically will not be covered by seller's D&O insurance. (As discussed below, absent aiding and abetting liability or a contractual indemnification obligation, unaffiliated third party buyers are unlikely to face exposure to court awarded damages.) - A second area that is put at risk is deal certainty. Plaintiffs in shareholder lawsuits customarily allege that the sale process was flawed and that deal protection provisions of the transaction impermissibly deter competing bidders from making alternative and potentially superior offers. Although the Delaware Chancery Court has been reluctant to enjoin attractively priced sales to third parties or to modify the terms of the acquisition agreement to impose "go shop" or other curative remedies upon an "innocent" buyer, at some point a court frustrated with continued sales process issues in spite of its normative opinions may find that the lack of a "deep pocket" to fund a post-closing damage award8 may outweigh the inequities of jeopardizing a transaction.9 In that case, an injunction or voluntary reformation of the acquisition agreement to provide for go-shops, lower breakup fees and fewer deal protections, may be the only alternatives left for the buyer. (Moreover, if competing bids are outstanding, the court's reluctance to enjoin could likely be overcome by the possibility of another – even if then lower – premium offer.) Therefore, the possibility of pre-closing remedies may subject the signed transaction to delay and greater market risk and leave it vulnerable to interlopers, all of which create uncertainty and put the transaction in jeopardy.
- A third area of concern is the potential liability that a buyer
may bear the economic cost of monetary damages for which directors
or officers or the acquired company may be held liable in a
post-closing trial as a result of indemnification arrangements. If
the acquired company indemnifies directors for these damages, the
buyer indirectly will bear the costs of any judgment. Typically
buyers will agree in an acquisition agreement to retain and
continue the indemnification provisions contained in the acquired
company's constituent documents for a specified period of time.
These provisions protect directors against claims based upon
alleged breach of duties of care, but, as a matter of law, do not
exculpate directors for conduct that is not in good faith or a
breach of the director's duty of loyalty. The effect of these
indemnification provisions in conjunction with most state law is to
insulate directors against claims for monetary damages for breaches
of duties of care. Consequently, damage claims against independent
directors alleging deficiencies in the sale process, including
violations of so-called Revlon duties to maximize the sale
price, must be based upon breaches of duty of loyalty. These
breaches would not be covered by the indemnification provisions in
the acquired company's charter and, therefore, would not expose
a buyer to increased cost (other than defense or settlement costs).
Moreover, Lyondell and other recent decisions have
reaffirmed that the standard for personal liability for outside
independent directors in post-closing Revlon claims
alleging breach of the duty of loyalty is very difficult to
meet.10 In Lyondell the Delaware Supreme Court
reversed the Court of Chancery by rejecting claims that
Lyondell's directors breached their duty of loyalty in
conducting a sale process, stating that an extreme set of facts is
required to sustain a claim that disinterested directors
intentionally disregarded their fiduciary duties. In El
Paso, discussed above, the court acknowledged the unlikelihood
that the independent directors of El Paso – who believed
the conflict of El Paso's financial advisor had been addressed
and were not aware of the CEO's self-interested motives
– could be held liable in monetary damages for their
actions. These opinions indicate that, absent unique, compelling
circumstances, the principal parties who remain at risk for
personal liability are really controlling shareholders, members of
senior management and a director in a conflict situation.
Nevertheless, buyers and their counsel should carefully review the
target's charter and bylaws (or similar organizational
documents) to assess the scope of the indemnification obligations
that will vest in the surviving corporation.
More importantly, occasionally buyers will also agree either in the acquisition agreement or in separate stand-alone agreements to grant the officers, directors and large stockholders (and possibly other agents) of the target additional indemnification rights covering all pre-closing activities to the fullest extent permitted by applicable law. Although these direct contractual rights to indemnification are outside the restrictions of Delaware statutory law, public policy considerations may still limit a buyer's ability to indemnify for breaches of the duty of loyalty (and any D&O insurance policies purchased to backstop buyer's indemnification obligations will not provide coverage if there has been a finding of a breach of the duty of loyalty). In any event, while breaches of directors' duty of loyalty are among the most frequent claims in derivative suits, as noted, those claims are very difficult to establish with respect to disinterested directors. Therefore, the most likely means by which a buyer might expose itself to claims for indemnification is if it has provided senior management or a controlling stockholder of the acquired company with a contractual indemnity extending beyond the protections afforded to these parties by the target company. Even if a court were to ultimately refuse to enforce indemnification of this type, the buyer could be exposed to potentially protracted litigation and uncertainty. Finally, liability can be a realistic possibility if a director, member of senior management or control stockholder in fact is in a conflict position with respect to the transaction. - Upon closing the buyer will also succeed to all contractual indemnification obligations of the target, including the target's obligation to indemnify its financial advisors under the bank's engagement letter. Typically financial advisors will be entitled to reimbursement, indemnification and contribution from the target in connection with its engagement and in any action related to the transaction brought by any person, including stockholders of the target, in each case subject only to a finding of willful misconduct or bad faith (or in some cases, gross negligence) by the bank in performing its services. In addition, the target is not permitted to enter into any settlement without the consent of the financial advisor, unless the settlement includes an unconditional release of the bank and its related parties from all liability and does not include any admission of fault or culpability by the bank. As a result, any settlement or award of damages against the financial advisor in a derivative suit will indirectly be borne by the buyer through its ownership of the target. One possible exception would be in circumstances where the bank is found liable for aiding and abetting a director's breach of his or her duty of loyalty – presumably the same acts (or omissions) that underlie the aiding and abetting finding also demonstrate bad faith or willful misconduct (or gross negligence), thereby cutting off the company's obligations to the bank under the engagement letter.
- Another concern for the buyer of a company with a flawed sales process is the right of target company stockholders to demand appraisal of the "fair value" of their shares when the purchase price is paid all or in part in cash. It has been unusual for courts to determine that a target share of stock has a "fair value" in excess of the sale price negotiated with an independent buyer. However, if a court suspects that the financial analyses or the negotiating process that led to the agreed purchase price was tainted or involves a conflict of interest, then it would likely more closely scrutinize valuations and could be more inclined to find that the appraised value of the shares exceeds the tainted per share price that was agreed to by the target.11 The result would impose a direct increase in acquisition cost on the buyer.
- A final potential hazard from the buyer's perspective is the risk that it could be found to have aided and abetted the target directors' breaches of fiduciary duty. In order to succeed on such a claim plaintiffs would have to show not only the existence and breach of a fiduciary duty, but also knowing participation in that breach by the buyer. This is not common but it is certainly a possibility and should not be ignored, particularly in circumstances where the buyer is aware that members of the target board or management have conflicted loyalties. In Del Monte,12 the court found that the plaintiffs had met this burden by showing that the buyout group knowingly participated in the self-interested activities of Del Monte's financial advisor, including by breaching the no-teaming provisions of its confidentiality agreement and agreeing to make the financial advisor one of the lead banks on the buy-side financing before the advisor had obtained clearance from Del Monte's board. These abuses may seem self-evident, but without a bright-line rule it is difficult to know what specific acts will be deemed impermissible. In Del Monte the court stated the general rule that "[a] third-party bidder who negotiates at arms' length rarely faces a viable claim for aiding and abetting", but noted that "a bidder may be liable to the target's stockholders if the bidder attempts to create or exploit conflicts of interest in the board." Short of creating or exploiting conflicts, are there other limits on a bidder's ability to take advantage of its negotiating leverage? In the court's opinion in El Paso, despite the deficiencies in El Paso's sale process, Chancellor Strine stated that he did not "find any basis to conclude that Kinder Morgan is likely to be found culpable as an aider and abettor. It bargained hard, as it was entitled to do." Chancellor Strine went on to note that, from Kinder Morgan's perspective, it appeared that steps were taken by the target and its financial advisor to address the potential conflicts of interest, that Kinder Morgan was not aware of the concealed interests of El Paso's CEO until after the agreement was signed, and that it had no reason to know that El Paso's CEO was acting without the consent of the El Paso board. It goes without saying that the result could be different if a buyer has knowledge of wrongdoing by the fiduciary or is perceived as exploiting a situation in spite of obvious warning signs. Generally, however, buyers should be free to negotiate robustly, use whatever leverage they have and employ tactics, such as "exploding" offers or preemptive bids, without concern about aiding and abetting liability.
What Can Buyers Do
These issues all raise the question whether there are ways for buyers to avoid or mitigate the risks that they assume when entering into transactions that become the subject of derivative suits. These concerns are particularly pronounced for private equity buyers because of their general intention to provide senior management of the acquired company with executive positions and meaningful post-closing ownership of the company, thus creating potential conflicts for management in negotiating sales price and other deal terms with the private equity firm.
In the first instance, buyers should be sensitive to those situations which will create the appearance of potential conflicts of interest or otherwise provide the basis for claims that the negotiating process was somehow improperly structured to the detriment of the stockholders of the acquired company. Among the factors that might lead a court to take so-called Revlon or sale-process claims more seriously are:
- the fact that the target CEO or senior management is pursuing the transaction or negotiating terms without prior board authorization, or if the CEO of the target is the sole negotiator in a private equity transaction without participation by an independent director or financial advisor;
- the target has publicly announced alternative strategies, such as the sale of certain assets or a spin-off and the seller is being advised by a "conflicted" advisor, perhaps along with an independent advisor (in which case the buyer should inquire whether the target's analysis of the proposed sale transaction has been compared to these alternatives in terms of merits to the target company's shareholders, including the financial analyses performed by the target's banker, and inquire whether the fee structure for the target's independent financial advisor materially favors a sale over any other alternative (as compared to status quo));
- the target CEO expects to have a significant role in the company post-closing with substantially modified compensation, such as a private equity deal or circumstances where the buyer is using the acquisition as a means of acquiring a new CEO or future successor to its current CEO;
- the buyer (or its affiliates) having a long-standing or significant relationship with the target's financial advisor, with the implication that negotiating advice and a fairness opinion would be tainted by the banker's desire to maintain its post-closing relationship with the buyer. This same issue is more emphatically presented if the financial advisor requests the opportunity to participate in the financing of the buy-out in which instance, at a minimum, the buyer must seek to determine if the target has given informed consent to this activity;
- common directors serving on the boards of both the buyer and the target;
- expectation that the buyer will sell assets shortly after the closing and either target management or the target's financial advisor are potential participants in that sales process;
- waiver of bid process guidelines or requirements, including standstill provisions, applicable to the buyer without clear target board (or board committee) authorization;
- request for a special (preferential) arrangement for one or a subset of shareholders, such as a premium to the acquisition price paid to the public, a different form of consideration to accommodate tax planning, or to reflect different classes of stock; and
- expected post-closing business relationships between the buyer and affiliates of the target, including one or more large stockholders.
Sensitivity to these situations and working with target company advisors to effectively eliminate conflicts for those representing the interests of the public stockholders of the target will best position the buyer and the acquired company to defuse potential litigation landmines.
Buyers themselves should of course avoid any conduct that could be viewed as interfering with target's fiduciary duties or exploiting any conflicts of interest of the target board, senior management or its advisors or significant stockholders. If a buyer is or becomes aware of any potential conflicts of interest or arrangements that the target's financial advisor or any of its directors or officers may have with respect to any other participant in the transaction, it should seek confirmation that the target has implemented appropriate structural devices to cabin the conflict. The buyer, of course, should not breach obligations imposed upon it, such as anti-teaming provisions or restrictions on furnishing target confidential information in a confidentiality agreement. That breach, in itself, could be a path to buyer liability.
Unfortunately, a buyer is not likely to become aware of any conflicts or other potential flaws in the sale process until after it has signed the acquisition agreement and subsequently is provided with a draft of seller's merger proxy, including its description of the background of the transaction. Buyers looking to satisfy themselves in advance of signing are likely to meet resistance from sellers who would view any due diligence into the sale process as intrusive and potentially undermining a seller's negotiating leverage. Currently, acquisition agreements give cursory attention to these issues. The agreement includes representations and warranties confirming the prior receipt of a fairness opinion and necessary board approval. One potential mechanism to address the gap on the sale process is to seek to insist that the target represent and warrant that its board (or applicable board committee) conducted the sale process in compliance with applicable laws in all material respects. Distinct from the general compliance with laws representation which excepts problems which would not result in a material adverse impact on the target, a process-compliance representation could be structured so that a breach gives rise to a right of termination by buyer and further, if the transaction is ultimately consummated, the acts or omissions that gave rise to the breach could be carved out of the buyer's contractual indemnification obligations. A more limited representation would call for the disclosure of any conflict of interest or potential conflict of interest affecting any target director, senior officer or financial advisor. Undoubtedly those types of representations would be the subject of intense negotiation and strongly resisted by sellers, but any incremental protection that can be obtained by buyers should help mitigate any potential risk they are taking on in these acquisitions.
In the end, despite their best efforts, acquirers can never eliminate the prospect of shareholder litigation and will always be "stuck with the risk of having dealt with potentially faithless fiduciaries."13 The Chancery Court decisions attacking the motives and faithfulness of target boards should equally alarm buyers and their advisors as to the perils of a flawed sale process. However, just as there is no one path a target board must follow in order to satisfy its fiduciary duties, there is no failsafe approach for buyers to insulate themselves from exposure in derivative suits, and each potential transaction will require a nuanced assessment of the associated risks.
Footnotes
1 In re Southern Peru Copper Corporation Shareholder Derivative Litigation, C.A. No. 961-CS (Del. Ch. Oct. 14, 2011).
2 In re El Paso Corporation Shareholder Litigation, C.A. No. 6949-CS (Del. Ch. Feb. 29, 2012).
3 In a 2008 decision by the Delaware Court of Chancery, McPadden v. Sidhu, 964 A.2d 1262 (Del.Ch. 2008), the court similarly held that a member of management who negotiated the sale of a subsidiary of a public company was potentially liable for post-closing damages because of the conflict created by his ownership interest in the purchaser of the subsidiary and his breach of the duty of care. The independent directors of the public company were not subject to a monetary damages claim even though they were grossly negligent in supervising the sales process because the company's charter exculpated them from liability for actions other than those taken in bad faith, which the court held required the directors to consciously disregard their duties.
4 In re Delphi Financial Group Shareholder Litigation, C.A. No. 7144-VCG (Del.Ch. March 6, 2012).
5 See Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions, Cornerstone Research, Inc. (2012) ("Cornerstone Report").
6 Cornerstone Report (based on available fee data for settlements in 2010-2011). The mode or most common amount was between $400k-$500k (Cornerstone Report), but settlements have the potential to be enormous (in Del Monte the court approved plaintiffs' fees of approximately $22 million).
7 As noted above, the court in Southern Peru awarded $1.26 billion in damages. Shareholder litigation stemming from KKR's buyout of Del Monte settled in October 2011 for approximately $89 million (including $22 million in attorneys' fees). The class-action suits brought against Kinder Morgan alleging breach of fiduciary duty in connection with its 2007 buyout were settled for $200 million in November 2010.
8 See El Paso, in which Chancellor Strine acknowledges that "Although [El Paso's CEO] is a wealthy man, it is unlikely that he would be good for a verdict of more than half a billion dollars." (El Paso, at 26.)
9 In Del Monte, amid alleged collusion among bidders and conflicting interests of Del Monte's financial adviser, the Court of Chancery issued a preliminary injunction delaying the shareholder vote on the proposed buyout of Del Monte Foods for 20 days in order to permit new bidders to emerge. Finding that the deal protection provisions were the result of the board's fiduciary breach, the Court also enjoined the parties from enforcing the no-solicitation covenant, the buyers' matching rights and the termination fee (in connection with a superior proposal) during the pre-vote period.
10 Lyondell Chemical Company v. Ryan, C.A. No. 3176 (Del. March 25, 2009).
11 See,e.g., In Re Emerging Communications, Inc. Shareholders Litigation, 2004 Del. Ch. LEXIS 70 (Del. Ch. May 3, 2004) (in which Justice Jacobs tried a consolidated litigation comprising a statutory appraisal claim and class action claims alleging breach of fiduciary duty by the acquired company's directors and awarded $38.05 per share to plaintiffs in the appraisal proceeding and $27.80 (the difference between the appraised value and the $10.25 per share deal price) to the plaintiff class).
12 In re Del Monte Foods Company Shareholder Litigation, Consol. C.A. No. 6027-VCL (Del. Ch. Feb. 14, 2011).
13 El Paso at 27.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.