Chancery Addresses Deficient Board Procedures in Approving Private Equity Transactions

Editor’s Note:This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Vice Chancellor Leo Strine, who teaches at Harvard Law each fall, last week issued an opinion with potentially significant implications for shareholder challenges to going-private transactions in In re Netsmart Technologies, Inc.  The opinion holds that a board may fail to meet its Revlon duties when it considers only bids from financial buyers–to the exclusion of strategic acquirers–and that a firm must disclose valuation opinions suggesting that the firm is worth more as a standalone entity in the merger proxy.

Netsmart‘s board considered only bids from financial buyers before signing a merger agreement with a window shopping provision.  (Although Netsmart was prohibited from soliciting a higher bid, the window shopping clause authorized them to accept an unsolicited bid.)  In cases involving larger firms, Chancery has suggested that window shopping clauses ensure that the board accepted the highest bid, for other bidders are free to step in and pay more.  But Netsmart is quite small, and the Vice Chancellor concludes on these facts that a window shopping provision offers little market assurance for small firms because other buyers might not know that the firm is in play and the company is prohibited from actively soliciting a higher bid.

Paul Rowe, a member of the Program on Corporate Governance‘s Advisory Board and a partner at Wachtell, Lipton, Rosen & Katz, has authored a Memorandum on the decision.  The Memorandum notes that the Netsmart board used an increasingly common approach to the auction, and that previous Delaware cases had approved window shopping provisions under different circumstances.  Emphasizing the fact-specific nature of the opinion, Paul concludes that Chancery will probably continue to defer to the judgment of boards in structuring the auction process, but that boards must ensure that the auction procedure they establish is appropriate in light of the particular circumstances of the merger market for the firm.

I agree with Paul that the opinion is quite fact-specific; there is considerable emphasis on Netsmart’s size and its corresponding likelihood of drawing a competitive bid without being able actively to shop the company.  But the opinion also evinces growing skepticism at Chancery with respect to the incentives of management, boards, and even financial advisors to sell to a financial buyer rather than a strategic acquirer.  As I noted in describing Vice Chancellor Lamb‘s decision in In re SS&C Technologies, Chancery seems acutely aware of the fact that managers seeking to preserve themselves in office might prefer to sell to a private equity firm rather than to a strategic buyer–and the court seems prepared to demand that boards design auction processes that do not favor management’s preferred result.

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One Comment

  1. Arthur Mboue
    Posted Wednesday, March 21, 2007 at 1:16 pm | Permalink

    Investors and external monitors don’t know what company’s REAL full health data are but they can predict a temptation to manipulate data by management from what ever they know of CEO’s action in own portfolio management and compensation package as to what the company’s likely full financial record is because the law of asymetric of information balances in favor of management when it comes to company’s real data. It is why selling shares of the company by CEO is a signal of market overvaluation of company’s shares. However, as long as the market would not be able to tell whether known or suspected sales of shares by CEO are due to CEO’s knowledge of negative financial records of the company or due to CEO’s liquidity needs (house building, children tuitions, new car needs, luxury vacation plan, shopping addiction,..) customers and shareholders will end up paying for these costs of speculations. Based on this argument, the advocacy of the market ability to identify CEO’s sales of shares will hurt the company’s value in case of CEO rights for own cash and financial privacy because unlike investors with opportunity of diversified and low risk portfolio, CEO only investment is his employing firm’s share portfolio. As we know, diversification always lessens volatility and threat of loss because investors portfolio carries more than 10 different companies shares and this absence of diversified portfolio empowers CEO with this title of residual risk bearers of the company. Although, today’s new development is vibratiing around CEO’s compensation package, there is still one extreme and fortunate window and opportunity availble to CEO to own and increase his wealth, it’s called Management Buy Out (MBO) or ‘Legal Insider Trade In’. It is true that existing management can recapitalize the company’s without selling it but management can also undervalue his company for a potential MBO with fraudulent freezing out of minority shareholders with high premium and more commonly aggressive accounting practices
    *Shifting current revenues of the company to after the BuyOut as a special premium, assets auction sales,..
    * Improperly hold back revenues before the BuyOut
    * Accelerating discretional ‘fake’ expenses into income after the BuyOut
    *Creating reserves and releasing them into income after the BuyOut
    In sum, in the post Enron culture, we must recognize that (I am not making any contributory argument here) these agressive and ‘cooked’ data and footnotes always win negligent and ‘do nothing’ SEC, informed investing public and other regulators’ approvals instead of large fines, criminal penalties and compliances sentences until these outsider tips, analysis, working papers or news articles.
    Arthur Mboue, MBA, JD, Adjunct law and Business faculty Research Fellow (affiliate)