A recent decision by the Delaware Court of Chancery found a director who was a former investment banker with experience in a particular industry held to a higher standard than non-expert directors in the context of mergers and acquisitions. Of the many current issues facing financial advisors, the much discussed, but as yet unpublished, potential new rules by the National Association of Securities Dealers regarding conflicts have received the most press coverage. However, this recent decision is equally deserving of attention.

Case Study: In re Emerging Communications, Inc.

In 1998, Jeffrey Prosser, the controlling stockholder of a Delaware telecommunications company, Emerging Communications (ECM), began to explore having another company he controlled, Innovative Communications Company LLC (ICC), acquire ECM in a going private transaction. In response to the advance, the ECM board formed a special committee, which hired separate legal and financial advisors, to negotiate on its behalf. After negotiations with Prosser and several increases to the initial offer price, the financial advisor found that the final $10.25 offer price was fair. The special committee recommended the transaction to the full board, and the full board approved the going private transaction. Although the tender offer was conditioned upon the tender by a majority of the shares held by the minority stockholders, two minority stockholders sued after the consummation of the transaction and sought appraisal and a ruling that the board of ECM had breached its fiduciary duties by agreeing to an unfairly low price.

The Court agreed with the minority stockholder plaintiffs and found the fair value of ECM’s shares was $38.05 per share. The Court based its conclusion, in part, on a set of projections prepared by ECM’s management, which was more optimistic than management’s initial set of projections. These optimistic projections were shared with Prosser but not with the rest of the board or the financial advisor.

Because the Court found neither the price nor the process undertaken by the ECM board was fair, the Court ruled that each of the directors breached their duty of care. The Court also found that Prosser breached his duty of loyalty by concealing the more optimistic projections from the rest of the directors. In addition to breaching his duty of care, the Court found one of the directors – Salvatore Muoio — had also breached his duty of loyalty by voting in favor of the going private transaction. Muoio was a principal and managing director of an investment advising firm who possessed what the Court described as "significant experience in finance and the telecommunications sector" because he had previously worked for a number of years at Lazard Freres & Co. and Gabelli & Co. Significantly, Muoio was not a member of the special committee. The Court held that Muoio breached his duty of loyalty because, based upon his experience as an investment banker in the telecommunications industry, he should have known the offer price was not fair, despite the fairness opinion from the special committee’s financial advisor. This is especially relevant given that ECM’s charter, like many companies’ charters, exculpates directors for breaches of their duty of care, pursuant to Section 102(b)(7) of the Delaware General Corporation Law, but by law cannot exculpate directors for breaches of their duty of loyalty.

The Court speculated that either "Muoio made a deliberate judgment that to further his personal business interests, it was of paramount importance for him to exhibit his primary loyalty to Prosser" or "Muoio, for whatever reason, ‘consciously and intentionally disregarded’ his responsibility to safeguard the minority stockholders from the risk, of which he had unique knowledge, that the transaction was unfair." Therefore, despite finding that Muoio did not do "anything affirmatively to assist Prosser in breaching his duties of loyalty and good faith," the Court found Muoio personally liable for the difference between the offer price of $10.25 per share and the price the Court found to be fair, $38.05 per share. The Court’s holding is, in effect, a warning to those directors with significant financial or other specialized expertise who may be held to a higher standard than other directors.

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