Canada: Private Equity And Other M&A Transactions: Whose Side Are You On?

The propriety of senior management engaging in discussions with potential private equity acquirors has been put into question a number of times in high profile cases over the past year. As fiduciaries of the corporation, senior management may place themselves into conflict if they engage in discussions with potential acquirors without reporting to the board and obtaining board authorization.

In Canada, the CEO and in-house counsel of Movie Distribution Income Fund were dismissed, in August 2006, amidst allegations that the officers had breached their obligations by not keeping the directors informed of their activities in shopping for a private equity investor. Last month, Dow Chemical Co. terminated a senior advisor (who was also a board member) and a senior executive, alleging that they had been engaging in unauthorized talks with a consortium of investors about making a bid for Dow. In these cases, the employees denied any wrongdoing.

Over the past few weeks, the CEO of BCE Inc. has come under scrutiny in the press for his involvement in the organization of a private equity consortium that is considering making a bid for that company.

Recently, in Netsmart¹, the Delaware Court of Chancery sounded an alarm regarding the potential for confl ict of interest in private equity transactions because, in this type of public to private transaction, management is more likely to continue to be employed and to receive an equity interest in the company.

In-house counsel’s challenge is to provide practical advice (i) to senior management regarding obligations to report to and obtain direction from the board and (ii) to the board regarding its obligation to supervise and to manage discussions and negotiations with potential acquirors.

It would be impractical and undesirable for boards to prevent senior management from identifying and negotiating with potential acquirors. However, senior management and directors must be mindful of the confl icts of interest that may develop when management is offered by the acquiror continuing employment and a continuing equity stake in the company. If a shareholder challenges the actions of directors and officers, the court will carefully review the process by which the directors supervised the negotiations and managed the exploration of alternative transactions.

MEASURING SUCCESS In assessing whether the board has discharged its fiduciary duties, the court will look at whether appropriate supervisory structures, such as a special committee of independent directors, were put into place in time to affect the sale process. The court will give less weight to the special committee’s deliberations if management, management’s advisors, or dominant shareholders actively participate in the deliberations.

1. Educate Senior Management. Educate senior management regarding their fiduciary obligations and the necessity to report regularly to and seek direction from the board on approaches made from or to potential acquirors.
2. Educate the Board. Educate the board regarding their fiduciary obligations and the obligation to supervise and manage a sale process from an early stage.
3. Review of Alternatives. Advise the board to ensure that the board has considered the corporation’s alternatives before deciding to explore or to discontinue exploration of a transaction with a potential acquiror.
4. Early Formation of Special Committees. Courts and security regulators encourage special committee oversight of management when considering or negotiating with a potential acquiror. In-house counsel should recommend that a special committee be formed early enough to have an impact on decisions regarding market testing and consideration of alternative transactions.
5. Independence of the Members of the Special Committee. Members of a special committee should be independent in the sense that they are not connected to management, any dominant shareholders or the potential acquiror.

^{1. In re Netsmart Technologies, Inc. Shareholders Litigation, Delaware Court of Chancery (Court File No. 2563-VCS), March 14, 2007.}

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