Delaware Court Considers Conflicts of Interest in M&A

On February 29, 2012, Chancellor Strine of the Delaware Court of Chancery issued an opinion that is highly critical of the sale process run by El Paso Corporation in connection with its $21.1 billion acquisition by Kinder Morgan, Inc. See In re El Paso Corporation Shareholder Litigation, No. 6949-CS (Delaware Court of Chancery). The Court focuses on various alleged conflicts of interest involving El Paso’s CEO and its financial advisor, which persuaded the Court that the plaintiffs have a reasonable probability of success on a claim that the merger was tainted by breaches of fiduciary duty. But despite the “disturbing nature of some of the behavior,” the Court concluded that the balance of hardships did not support a preliminary injunction because the “stockholders should not be deprived of the chance to decide for themselves about the Merger.”

As set forth in the Court’s opinion, the CEO of El Paso undertook sole responsibility for negotiating the sale of the company, and failed to disclose to the Board of Directors his interest in working with other El Paso managers in making a bid to buy El Paso’s exploration and production business from Kinder Morgan following completion of the merger. In the Court’s view, this conflict was compounded by the fact that El Paso relied in part on advice given by its longtime financial advisor, which owned 19% of Kinder Morgan (a $4 billion investment) and controlled two Kinder Morgan board seats. On top of this, the lead banker to El Paso personally owned approximately $340,000 of Kinder Morgan stock, which remained undisclosed throughout negotiations.

The Court’s opinion underscores a number of important points M&A practitioners should be mindful of in connection with a sale process:

• A CEO should not be the sole negotiator in the sale process, particularly under circumstances where a potential conflict of interest exists or could arise, such that the CEO’s incentives to maximize price for stockholders could be questioned. Furthermore, any such potential conflict of interest should be promptly reported to the full Board. We note, however, that the Court appears to signal that even had that disclosure occurred prior to signing a deal, the CEO’s potential conflict would have still tainted his ability to negotiate on behalf of stockholders.
• The Delaware Court will take a very skeptical view of any efforts by a financial advisor with a significant conflict of interest to cleanse such conflict in a manner that that does not involve its substantial recusal from a continuing M&A advisory role. It is noteworthy that, except for the $340,000 of Kinder Morgan stock owned by the El Paso lead banker, the Court admits that all relevant potential conflicts involving El Paso’s financial advisor and its interest in Kinder Morgan had been disclosed. Notwithstanding such disclosure, the Court questions the decision of allowing the conflicted financial advisor to continue to provide advice to the Board regarding the potential sale to Kinder Morgan, and appears to view any advice given by the advisor in support of the decision to sell to Kinder Morgan as tainted by the conflict.
• Bringing in a second financial advisor will not be adequate to resolve conflicts of interest if an incentive structure is created such that the new advisor’s fee is linked to a successful deal that is in the interest of the original advisor. In El Paso, the Court was critical of the fact that the second financial advisor retained by the Board would only receive a fee if El Paso adopted the strategic option of selling to Kinder Morgan, and would not receive any fee if a spin-off transaction that was then contemplated by the company was completed Advisors will have to consider the Court’s view in light of the common business preference of a target board to pay a substantial M&A advisory fee only if a sale transaction is actually completed.
• The Court criticizes the lack of more aggressive negotiating tactics on the part of El Paso, particularly when Kinder Morgan reduced its initial private bid. The Court implies that a suspension of discussions or calling the buyer’s bluff to launch a hostile bid might have been better alternatives than continuing discussions at the revised price level. Sellers and their advisors will have to continue balancing the Court’s preference for a record showing aggressive negotiations, and the business realities and dynamics of the particular transaction.

It is noteworthy that the Court’s decision not to issue a preliminary injunction in light of the potentially serious conflicts of interest and the questionable decisions made by the Board conflicts with the decision in In re Del Monte Foods Company Shareholders Litigation. In that case, Vice Chancellor Laster issued a preliminary injunction enjoining a stockholder vote on the proposed merger for a period of 20 days, and further enjoined the enforcement of specific deal protection measures pending the vote, in light of alleged improper actions on the part of the company’s financial advisor. In El Paso, the Chancellor clearly expresses his view that it is not appropriate for the Court to interfere with stockholders’ right to vote for or against a transaction, absent a credible rival bid. The Chancellor also notes that the Court should not use its authority to reform a merger contract negotiated by sophisticated parties, including no-shops and termination rights, without an evidentiary hearing or undisputed facts.

Chancellor Strine’s opinion highlights the continuing heightened level of skepticism that the Court will display towards the actions of fiduciaries and advisors that may appear to be tainted by potential conflicts of interest. But the opinion also serves as a strong statement from the Chancellor of the proper role of the Court in merger situations where no rival bid has emerged and stockholders can exercise their informed vote to accept or decline a merger proposal.