United States: Directors’ Fiduciary Duties After Netsmart

In the first quarter of this year, the Delaware Court of Chancery issued a decision that should cause directors to carefully consider whether they have done enough to canvass the market of potential acquirers when their company is up for sale or, in other words, whether they have effectively discharged their Revlon duties. In In re Netsmart Technologies, Inc. S’holders Litig., the court enjoined a proposed cash-out merger between Netsmart Technologies, Inc. and two private equity firms, Insight Venture Partners and Bessemer Venture Partners. The court held that the Netsmart board of directors and special committee each breached their fiduciary duties "to undertake reasonable efforts to secure the highest price realistically achievable given the market for the company" when they only surveyed potential financial buyers (and no strategic buyers) during the then-present sale process. The court also held that the proxy statement distributed by Netsmart to its stockholders was materially incomplete for failing to disclose the projected future cash flows used by Netsmart’s financial advisor to support its fairness opinion. However, due to the court’s concern that the buyer would walk away from the deal if it required the Netsmart board to shop the company to a broader audience, the court limited the injunction to delaying the stockholder vote on the merger until Netsmart amended its proxy statement to disclose the reasons for not exploring the market of strategic buyers and the projected future cash flows used by its financial advisor.

Netsmart was a NASDAQ micro-cap company and a leading supplier of enterprise software solutions to health and human services providers and payors. From 1999 to 2006, Netsmart’s management and its financial advisor had sporadic, unfocused discussions with several potential strategic buyers, and these discussions were met with very little enthusiasm. Following Netsmart’s acquisition of its largest competitor in October 2005, however, several private equity firms approached Netsmart, expressing interest in acquiring the company. Because of its perceived past failure to attract strategic buyers, Netsmart’s management decided against pursuing strategic buyers and encouraged Netsmart’s board of directors to focus on an expedited auction process focused solely upon potential private equity buyers. After this strategy was adopted, Netsmart’s board formed a special committee of independent directors to safeguard the interests of Netsmart’s non-management stockholders. In early 2007, Netsmart entered into a merger agreement with Insight and Bessemer. The merger agreement contained a window-shop provision that allowed Netsmart’s board to consider an unsolicited superior bid, a fiduciary out and a 3 percent break-up fee in the event Netsmart terminated the merger agreement to pursue a superior bid. After Netsmart failed to receive any higher bids, Netsmart sent out proxies calling for a special stockholder meeting to vote on the merger. Several groups of shareholders sought a preliminary injunction against the consummation of the merger, which the court granted.

The court held that the Netsmart board of directors and special committee failed to take reasonable steps to secure the highest price realistically attainable and thus breached their Revlon duties. Although the court noted that Revlon does not "require every board to follow a judicially prescribed checklist of sales activities," the court was quite critical of the sale process used by the Netsmart board and independent committee. First, the court noted that Netsmart’s board, independent committee, management and financial advisor never made any serious attempt to survey the strategic market and develop a core list of potential strategic buyers "for whom an acquisition of Netsmart might make sense." In this vein, the court found the small number of informal, unfocused contacts between Netsmart’s management and financial advisors, on the one hand, and potential strategic buyers, on the other hand, prior to the decision of Netsmart’s management and board to begin the sale process to be cursory and poorly documented, and distinguished such efforts from a targeted, controlled and discreet sales effort aimed at select strategic buyers.

Second, the court also noted that it was unreasonable for Netsmart’s independent committee to rely upon the window-shop, fiduciary out and break-up fee provisions in the merger agreement as a feasible method for obtaining the highest price reasonably attainable for a company like Netsmart, especially since such provisions would require a strategic buyer to publicly disclose its intent to make a superior bid without having any discussions with Netsmart’s management or any access to due diligence. While prior Delaware cases have held similar post-signing market checks to be sufficient in numerous large-cap company sales, the court found the market dynamics to be very different for Netsmart as a micro-cap public company. As a result, a post-signing market check "does not, on this record, suffice as a reliable way to survey interest by strategic players" at such a late stage in the merger process.

Lastly, the court criticized a number of company actions, including (i) the timing of the formation of the independent committee after Netsmart’s management and board approved the sales process directed at a limited number of private equity buyers, (ii) that Netsmart’s management conducted the due diligence process without supervision, and (iii) that the minutes for key meetings of Netsmart’s board and independent committee were either missing, lacked detail or were prepared months after the actual meetings.

The court also held that the proxy statement distributed by Netsmart to its stockholders was materially incomplete for failing to disclose the projected future cash flows used by Netsmart’s financial advisor to support its fairness opinion. As the court noted, it is well settled that the board of directors of a Delaware corporation must "disclose fully and fairly all material information within the board’s control when [it] seek[s] shareholder action," and that "[a]n omitted fact is only material if there is a substantial likelihood that it would be considered important in a reasonable shareholder’s deliberation and decision making process before casting his or her vote." In the present case, the proxy statement distributed to Netsmart’s stockholders failed to disclose the final projections of Netsmart’s expected future cash flows that were used by Netsmart’s financial advisor in support of its fairness opinion. The court found that this failure to disclose Netsmart’s expected future cash flows as of the time that Netsmart’s board approved the merger agreement was material because Netsmart’s stockholders were being asked to approve a cash-out transaction, forsake any future gains from Netsmart’s ongoing operation and waive their appraisal rights. The court thus held that the company had to disclose to the stockholders the final projections used by its investment banker to prepare its discounted cash flow model and fairness opinion.

The court in In re Netsmart did not change the holding in Revlon, it merely reiterated that there is no single approach to conducting a sale process. The particular method used in light of the specific circumstances must result in a reasonable approach to achieve the highest possible price. Based on the record presented In re Netsmart, the court found that reliance on a post-signing market check was insufficient for a micro-cap company such as Netsmart. Overall, the issues raised underscore the need to involve experienced counsel as early as possible in a transaction involving the sale of control of a company.

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