18 February 2008

Private Equity MBOs And The Delaware Court Of Chancery: The Taming Of The Few

Potter Anderson & Corroon


Potter Anderson & Corroon
The Delaware Court of Chancery has lately issued a series of decisions that confront the special conflicts and resulting fiduciary issues that frequently arise in such circumstances.
United States Finance and Banking
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Reflecting the recent spate of private equity acquisitions, so often accomplished in partnership with the target's senior management, the Delaware Court of Chancery has lately issued a series of decisions that confront the special conflicts and resulting fiduciary issues that frequently arise in such circumstances. In the view of some, these opinions imply a notable judicial cynicism, if not an unstated escalation of judicial scrutiny, in connection with the review of challenges to such transactions. An enhanced standard of judicial review with respect to the sale process in such circumstances is of course to be expected with respect to the typical private equity MBO; the typical factual patterns presented necessarily bring them within the application of Revlon, thus subjecting the target board to the special obligation imposed by that venerable precedent to take pains to secure the highest and best price reasonably available. But the language of these opinions seems to venture beyond the mere insistence that directors adhere to the standard of an objective and reasonable auctioneer, seeming instead to focus on inherent conflicts of interest arising from management's participation on the sell side. The fact patterns do not involve the archetypal enemies of broad judicial deference to the decisions of independent, honest and careful directors. There are no self-dealing majority stockholders, no majority of conflicted or indifferent directors, no formal (and always difficult to establish) allegations of domination or control. Nonetheless these cases appear to reflect a degree of judicial suspicion and scrutiny that, although arguably justified by the application of the Revlon mode of analysis, seems of a sort more typically reserved for circumstances that invoke entire fairness review.

In re SS&C Techs., Inc., S'holders Litig., 911 A.2d 816, (Del. Ch. 2006)

The SS&C decision is the first Court of Chancery decision to have identified salient issues of concern peculiar to private equity MBOs. While, by virtue of its unusual procedural posture, it offered no definitive road map to the resolution of the questions it rather pointedly raised, the nature and tenor of the Court's expressed concern went far in foreshadowing the more searching precedents to come over the course of the next several months.

The opinion itself arose in somewhat indirect fashion pursuant to a joint request for judicial approval of a proposed settlement of the shareholder representative action that had attacked the transaction at issue. That transaction contemplated a cash-out merger led by the target's management and supported financially by Carlyle Investment Management LLC, a private equity investment company. The primary management protagonist was William Stone, the Chair and CEO of SS&C, whose prearranged alliance with Carlyle for purposes of the proposed acquisition contemplated that he personally would roll over a large percentage of his considerable equity and options in the company into an even more significant equity position in the survivor. His deal with Carlyle also permitted him to sign a new employment agreement, keeping him at the helm of the business when the public investors had gone. He also was to receive the merger consideration in exchange for the balance of his SS&C equity interests, amounting to some $76 million in cash.

The sheer abundance of the deal from Mr. Stone's happy perspective, indecorous as it may have appeared, is not what caught the Court's experienced eye, however. More provocative was the fact that Mr. Stone allegedly had taken it upon himself to initiate a search for a bidder on just such personally bountiful terms, all without authority from or notice to his board. Indeed, plaintiffs claimed, Stone and his bankers met, without the board's knowledge, with no less than six private equity firms, each of which was informed that any deal would be conditioned on terms that ensured Stone's equity participation in and continued employment with the survivor. Only after having successfully induced a bid from Carlyle that met his prerequisites did Stone approach his board to announce that he and Carlyle wished to take the company private.

Aside from the fact that it was necessarily a bit late to act, the board nonetheless responded in orthodox fashion, appointing an independent committee, retaining independent advisors and authorizing a simultaneous effort to look for alternatives and to negotiate for a higher bid from Carlyle. When no other offers surfaced, and Carlyle agreed to bump its initial offer, albeit by a paltry 1%, the committee approved the deal. A settlement of the

litigation with counsel for the complaining shareholders was quickly reached in the wake of this agreement, consisting primarily of supplemental proxy disclosures, and the transaction closed.1

Upon the ensuing presentation of the settlement for approval, the Court flatly rejected it, in part on the grounds that the Vice Chancellor found himself unable to conclude that the seemingly weighty claims being released with regard to the sale process were equal to or smaller in value than the benefits to be conferred on the shareholders by the settlement, the critical prerequisite for the approval of representative settlements under Delaware law. In particular, the Court observed, Stone's decision to conduct a renegade search for a buyer, and to conduct negotiations designed in the first instance to serve his own personal interests and demands, raised a host of fiduciary issues on which the record, derived exclusively from post-settlement confirmatory discovery, failed to cast any informative light. The Court thus found itself less than adequately reassured with respect to a number of issues it deemed critical to a meaningful evaluation of the fairness of the proposed settlement.

... did Stone misuse the information and resources of the corporation when, acting in his official capacity but without board authorization, he hired an investment banker to help him identify a private equity partner to suit his needs? ... whether, given Stone's precommitment to a deal with Carlyle, the board of directors was ever in a position to objectively consider whether or not a sale of the enterprise would take place. Similarly, did Stone's general agreement to do a deal with Carlyle make it more difficult for the special committee to attract competing bids, especially from buyers not interested in having Stone own a significant equity interest in the surviving enterprise? And, did Stone's negotiation of a price range with Carlyle unfairly impede the special committee in securing the best terms reasonably available. These are only some of the important legal issues that result from the way Stone and the board of directors formulated the private equity buy-out of SS&C Technologies.2

This SS&C decision obviously identifies more issues than it resolves. In the course of doing so, however, it presaged the nature of the Court's analysis going forward with respect to private equity MBO transactions and, in particular, signaled the importance that the Court was to accord to the target board's effectiveness in dealing with and controlling the inherent conflicts that can so easily arise in such circumstances. Such cases were quick to follow.

In re Netsmart Techs., Inc. S'holders Litig., C.A. No. 2563-VCS, 2007 Del. Ch. LEXIS 35 (Del. Ch. Mar. 14, 2007)

Netsmart Technologies was a small but publicly-held healthcare enterprise software company. After receiving some largely unsolicited feelers from private equity firms expressing preliminary interest in acquiring the company, the Netsmart CEO, Conway, began seriously to consider the possibility of a going private transaction led by such a buyer. He arranged for the board to take under advisement a range of strategic options, a sale to a financial buyer prominently featured among them. Ultimately and, the opinion suggests, pursuant to Conway's influential urging, the board authorized its banker to try to sell the company and in the process to eschew, at least initially, contacts with potential strategic suitors and to focus exclusively on potential private equity buyers instead. The basis for this tactical decision was said to be the conclusion by the board, informed by previous, albeit abbreviated, experience (described by the Court as "erratic, unfocused and temporally disparate discussions"3), that any likely strategic acquirors would either view the company as too small or its market segment too narrow to justify their interest, and the concomitant risk that approaching direct competitors would be detrimental to the Company's competitive position.

A Special Committee of the board was formed and, retaining the company's banker as its own, it proceeded to contact several private equity firms in an attempt to gauge their interest in an acquisition. When several of the identified candidates asked for additional information, management, largely unsupervised by the Special Committee, handled the ensuing due diligence process.4 In the end, all of the bids submitted as a result of the due diligence process envisioned a continuing role for target management and equity incentives with the resulting entity.

The process from this point forward appears to have proceeded more or less routinely. The Committee identified the two most attractive bids and invited them to conduct additional due diligence and to participate in another bidding round. In narrowing the range of suitors, the Committee expressed confidence, based upon the advice of its legal representatives, that the public announcement of a deal that did not include preclusive deal protections would create the opportunity for a topping bid by another buyer, in particular a strategic buyer to make a topping bid. The highest bidder eventually withdrew, but the remaining contender weighed in with a bid only slightly lower, and a deal was struck.

The ensuing arm's-length bargaining resulted in a merger agreement with a standard window shop provision that allowed Netsmart to consider unsolicited superior proposals, incorporated a 1% reverse break up fee triggered upon exercise of the buyer's financing out and a termination fee of 3% of the deal's implied equity value, including expenses triggered only in the event of Netsmart's termination to pursue a superior proposal.

Negotiations between the buyer and Conway with regard to their incentives proceeded in parallel with the knowledge but without the active involvement of the Committee. While they did result in a new employment agreement and equity participation for Conway in the new entity, they did not, in the words of the Court, make Conway a "markedly richer man."5

The Court began its legal analysis of the ensuing shareholder motion to preliminarily enjoin the deal with an examination of the Revlon standard,6 helpfully observing that this duty "does not, of course, require every board to follow a judicially prescribed checklist of sales activities," but rather "to act reasonably, by undertaking a logically sound process to get the best deal that is realistically attainable."7

Unlike the bare rationality standard applicable to garden-variety decisions subject to the business judgment rule, the Revlon standard contemplates a judicial examination of the reasonableness of the board's decision-making process. Although linguistically not obvious, this reasonableness review is more searching than rationality review, and there is less tolerance for slack by the directors. Although the directors have a choice of means, they do not comply with their Revlon duties unless they undertake reasonable steps to get the best deal. 8

The Court then applied these general principles to the two primary questions raised by plaintiffs with respect to the sales process: whether the Committee failed to act reasonably in extracting the highest available price from the universe of identified private equity bidders; and whether the board's failure to include within its search possible strategic acquirors was unreasonable conduct that precluded the conclusion, required in order to pass muster under Revlon, that the process produced the best deal reasonably available. As to the first, the Court was unmoved by the allegations, characterizing plaintiffs' criticisms as mere quibbles with negotiating tactics. Conceding that the extent to which Conaway had been permitted to participate in the Committee's deliberations and to oversee the due diligence process was troubling, and in other "easily imagined circumstances" might prove "highly problematic,"9 "the allegations that Conway dominated the Special Committee and drove it toward an inferior offer are not convincing."10 "Unlike some other situations," the Court pointedly observed,

this was not one in which management came to the directors with an already baked deal involving a favorite private equity group. Conway had no preexisting relationships with any of the invited bidders. None of the bidders was offering materially more or less to management.11

The Court then turned to plaintiffs' second challenge under Revlon: had the board's search for alternatives been sufficient to support its conclusion that it had secured the best available deal? This contention found greater purchase. Unimpressed with the documentation supporting the board's determination not to exclude strategic suitors from the outset, unpersuaded by the board's reliance on abbreviated experiences with potential strategic suitors from several years before, and seeming to harbor a vague suspicion that this approach too conveniently served the personal interests of Conway and his fellow officers,12 the Court found that plaintiffs were likely to succeed on this claim at trial. In so concluding, the Court disdained defendants' suggestion that confidentiality concerns justified their decision to avoid, at least initially, an approach to strategic competitors ("...there is no record basis to believe that strategic acquirors (which have their own confidentiality concerns) were more likely to leak than private equity firms."). It also deemed unconvincing the board's reliance on the existing market trend in which private equity buyers regularly outbid strategic buyers. Most important, perhaps, the Court declined to credit the fact that the board's sales process and the resulting merger agreement were in keeping with a technique that seemingly had been viewed with approval in prior decisions of the Court and that was widely regarded by practitioners as the substantive equivalent of a broad pre-agreement market check for purposes of Revlon review: the use of a limited auction to secure a "bird in hand" coupled with a "window shop" provision, a relatively loose fiduciary out and a modest break-up fee in the resulting merger agreement, effectively leaving open the opportunity to receive and accept higher bids from alternative and unexpected bidders prior to closing. While observing that such a strategy might well be deemed a reasonable and sufficient substitute for a full pre-signing process in more typical market circumstances, the Court eschewed the suggestion of a bright-line rule to that effect. In this specific instance, the Court concluded that, in the absence of an unrestricted, pre-signing canvass of the market, the cleansing effect of employing relatively loose deal protection terms turns importantly on the extent to which the suitors originally excluded from the process will become cognizant of the residual deal jumping opportunity left open by the merger agreement. Here, the Court concluded that such bidders likely were not sufficiently aware of that opportunity to make the post-signing market check a reliable indicator that there were no other interested buyers. The Court's determination turned upon the target's relative obscurity. A "micro-cap" size company in a niche market, Netsmart had a relatively thin float and was being covered by only one research analyst. As a result, the Court was disinclined to credit an inert, post-signing market check as sufficient evidence to sustain the conclusion that the board had secured the highest and best transaction reasonably available, as Revlon requires. "Rather, to test the market for strategic buyers in a reliable fashion, one would expect a material effort at salesmanship to occur.... In the case of a niche company like Netsmart, the potential utility of a sophisticated and targeted sales effort seems especially high."13

In the absence of such an outreach, Netsmart stockholders are only left with the possibility that a strategic buyer will: (i) notice that Netsmart is being sold, and, assuming that happens, (ii) invest the resources to make a hostile (because Netsmart can't solicit) topping bid to acquire a company worth less than a quarter of a billion dollars. In going down that road, the strategic buyer could not avoid the high potential costs, both monetary (e.g., for expedited work by legal and financial advisors) and strategic (e.g., having its interest become a public story and dealing with the consequences of not prevailing) of that route, simply because the sought after prey was more a side dish than a main course. It seems doubtful that a strategic buyer would put much energy behind trying a deal jump in circumstances where the cost-benefit calculus going in seems so unfavorable.14

Based on this analysis, the Court concluded that the plaintiffs were reasonably likely to prove at trial that the board's failure to include potential strategic bidders in their pre-signing search was unreasonable and in breach of their Revlon duties.

The plaintiffs also challenged the propriety of the company's disclosures in seeking shareholder approval of the proposed merger on a variety of grounds. The Court declined to fault defendants for having failed to include certain preliminary projections that were more pessimistic than those that were disclosed in the proxy, or for not having more expansively dealt with simultaneous service of Conway and members of the Special Committee on third party boards, only vaguely identified by plaintiffs. The Court ruled, however, that the proxy statement improperly omitted management's final revenue and earnings projections as specifically utilized by the company's financial advisor in issuing its fairness opinion and presented to the company's board in support of that opinion. Although these projections were never provided to any bidder, and the financial advisor claimed to have placed little weight on them in formulating its opinion, the Court held that they were not only directly relevant and material to the stockholders' ability to evaluate the company's future prospects relative to the cash merger consideration being offered, but probably among the disclosures most "highly-prized" by investors given management's uniquely informed view of the company's prospects. 15

Once a board broaches a topic in its disclosures, a duty attaches to provide information that is "materially complete and unbiased by the omission of material facts." For this reason, when a banker's endorsement of the fairness of a transaction is touted to shareholders, the valuation methods use to arrive at that opinion as well as the key inputs and range of ultimate values generated by those analyses must also be fairly disclosed.16

Having concluded that plaintiffs had shown a probability of success in proving a Revlon violation in connection with the challenged transaction and in establishing a material omission from the company's proxy statement in connection with the imminent stockholder vote, the Court turned to an examination of the remaining conjunctive prerequisites for preliminary injunctive relief: the existence of a threat of imminent irreparable harm in the absence of such an order and a balance of the equities suggesting that the entry of such an order will do more good than harm. The Court confirmed the well-understood principle that irreparable injury almost invariably is threatened where stockholders are being asked to make important decisions without all material information relevant to that decision. Moreover, rejecting defendants' assertion that a damage award after trial would suffice to compensate for any alleged Revlon violation, the Court observed that such a violation typically was regarded under Delaware law as threatening irreparable injury as a theoretical matter, as any damage award would be

necessarily speculative. As a practical matter, however, the Court noted that such injunctions seldom issue with respect to Revlon violations when there is no higher priced alternative bid on the table because the effect of such an order would be to preclude the stockholders from deciding for themselves whether to accept the only deal available to them. Because the integrity and legitimacy of that choice is importantly reliant on the sufficiency of the information disclosed to them in making their choice, however, the Delaware courts have been willing to employ their injunctive powers to rectify disclosure deficiencies even where there is no competing bid to be had. In such a circumstance, the Court observed, "a decision not to issue an injunction maximizes the potential that the crudest of judicial tools (an appraisal or damages award) will be employed down the line, because the stockholders' chance to engage in self-help on the front end would have been vitiated and lost forever." 17

Drawing its conclusion from the intersection of these analytical concepts, the Court concluded that irreparable injury was threatened to the extent that the stockholders would be forced to express their choice whether to accept the pending transaction in the absence of the improperly omitted information. Once this additional information was supplied to shareholders, however, the balance tipped against injunctive relief because such an order could result in the evaporation of the proposed transaction, the elimination of the shareholders' opportunity to make an informed choice, and the inequitable reconfiguration of a deal legitimately bargained for by the otherwise innocent buyer. The Court therefore determined to issue a limited injunction against the stockholders' vote on the merger, but only until the proxy materials were supplemented to remedy the identified deficiencies and to include the Court's opinion so as to alert shareholders of the flaws in the negotiation process leading to the transaction under consideration.

With full information, Netsmart stockholders can decide for themselves whether to accept or reject the Insight deal. If they are confident that the company's prospects are sound and that a search for a strategic buyer or higher-paying financial buyers will bear fruit, they can vote no and take the risk of being wrong. If they would prefer the bird in hand, they can vote yes and accept Insight's cash. Because directors and officers control less than 15% of the vote on the most generous estimate, the disinterested Netsmart stockholders are well-positioned to carry the day, and most of them are institutional investors. 18

Upper Deck Co. v. Topps Co. (In re Topps Co. S'holders Litig.), 926 A.2d 58 (Del.Ch., 2007)

The Topps decision afforded the Court of Chancery the opportunity to consider, in the context of a proposed private equity MBO, the sufficiency and effectiveness of the inclusion of a go-shop provision in a merger agreement executed without the benefit of a pre-signing market check for purposes of judicial review of the board's approval of the transaction under Revlon.

In 2005, the classified Topps board confronted a difficult proxy fight over the election of certain of its incumbent directors. The dissidents, who were urging the incumbent board to explore strategic alternatives for the company, ultimately agreed to withdraw their challenge, but only in exchange for a pledge from the board to intensify its efforts to explore alternatives and a promise not to adopt a poison pill without stockholder approval over the course of the ensuing year. Thereafter, the board undertook an auction to sell one of its principal businesses, but the effort yielded no serious bidders.

This misfire prompted a renewal of the insurgents' attempt to elect three directors to the board in connection with the 2006 election of directors. Among the incumbents up for reelection in this instance was the company's CEO, Arthur Shorin, whose father had founded the company and who owned approximately 7% of the company's outstanding equity. This time, the dissidents campaigned on an unvarnished platform that urged an aggressive effort to sell the company in a going private transaction. To avoid the perceived prospect of imminent defeat, the incumbents again sought and secured an agreement to avoid a contested election, in this instance to expand the board so as to add the three insurgent nominees to the board while also retaining the incumbents.

Shorin's public statements during this volatile period to the effect that Topps was not looking for a quick sale of the company in order to assuage the shareholder unrest did not discourage unsolicited bids to acquire the company. Two financial buyers indicated interest in a potential transaction in a price range between $9 and $10, but backed away following due diligence review, apparently concluding that this price range was too rich.

During the course of the second proxy fight, Shorin was also contacted by Michael Eisner, the former CEO of Disney and private equity investor, who indicated at a meeting with Shorin that he was interested in being "helpful," presumably by proposing a going private transaction. Shortly thereafter, Eisner followed up with Shorin, indicating that he was interested in exploring the possibility of such a deal. Shorin suggested that Eisner speak to Stephen Greenberg, a long-serving independent director on the Topps board. Greenberg had previously met Eisner personally during the Disney days, having sold his business to ESPN, a Disney subsidiary, and during the ensuing year had served as an ESPN employee. In his ensuing discussion with Greenberg, Eisner suggested that he was unlikely to offer a price in excess of the then-current trading price of approximately $9. Greenberg advised Eisner that this was likely too low for the incumbent directors, who were more likely to regard as appropriate a price of not less than $10 a share (a 10% premium), and that the position of the dissident directors as to price was as yet unknown.

At the time of Eisner's inquiry, the board, in keeping with the terms of the settlement of the most recent proxy contest, was in the process of creating a committee to explore and evaluate strategic alternatives. As formed, the four-man committee consisted of Greenberg, Allan Feder, also an independent incumbent director, and two of the newly-elected dissidents. Greenberg reported his discussion with Eisner to the committee, causing one dissident member to worry aloud that suggesting so high a price might scare Eisner away.

As the committee discussed a variety of alternatives in addition to a sale over the course of numerous meetings, Eisner proposed a transaction at $9.24, approximately a 6% premium over the trading price. The two dissident members of the committee urged summary rejection of the Eisner proposal and the commencement of a public auction process. Greenberg and Feder, Greenberg's fellow incumbent director on the committee, were skeptical that auction would result in a better price in light of prior events, fearful of the effect on the company if an auction should fail, and concerned that Eisner would withdraw his attractive offer if an auction were initiated, as Eisner pointedly had threatened to do. They urged continued discussions with Eisner to improve his proposal.

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.

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