Troubling Signs from Recent M&A Case Law

Ethan Klingsberg is partner and Victor Ma is an associate at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum, and is part of the Delaware law series; links to other posts in the series are available here.

Have we forgotten the lessons of the Delaware cases that arose from the heyday of big-ticket LBOs by private equity preceding the financial crisis of 2007-2008? And to the extent we have, who is bearing the cost, how are plaintiffs uncovering these recent deviations from best practices, and what is to be done?

In these cases from the mid-2000s, courts consistently viewed LBOs as transactions marred by the conflicts of target company executives. Notwithstanding the presence of supermajority independent boards at the target companies, the courts regularly denied motions to dismiss breach of fiduciary duty claims in connection with LBOs. The focus was the absence of safeguards to neutralize the interests of these executives in working for the financial sponsor buyer after the closing and in having access thereafter to, as one case from that era described it, “a second bite at the apple” when the private equity firm would inevitably flip or IPO the company. [1]

A number of useful protocols grew out of these cases from the 2000s. [2] But the 2000s are now a long time ago and a new generation of gatekeepers (lawyers, bankers, and independent directors, not to mention private equity professionals and their friends in senior management of target companies) for whom those cases may be distant memories at best, are now in prominent roles. In the second half of 2020, two of the most important M&A cases involved alleged missteps that adherence to the protocols arising from the 2000s would have prevented.

The first case involved a merger of equals rather than a private equity buyout, but the misstep is one on which the private equity cases of the 2000s repeatedly focused. In City of Fort Myers General Employees’ Pension Fund v. Haley, [3] a public company CEO, whom the board had designated as its lead negotiator for the merger, failed to disclose an extraordinary compensation package that representatives of the other merger party had told him he would receive at the combined company. The Delaware Supreme Court reversed the Court of Chancery’s dismissal of the fiduciary duty claim against the CEO, on the grounds that his compensation package was material information about which the CEO should have posted the board while he was serving as a key source of information for the board about this bet-the-company transaction. The high court also remanded the aiding and abetting claims against those who conveyed the news to the CEO about his post-closing compensation prospects.

A longer list of alleged blunders emerges from the Court of Chancery’s denial of the motion to dismiss fiduciary duty claims against the CEO/chairman and COO/CFO of the target company in connection with a $1.9 billion LBO in In re MINDBODY, Inc., Stockholders Litigation. [4] Here, the CEO/chairman allegedly:

  • failed to inform his board about a series of contacts he had with the eventual private equity buyer—these contacts included discussions of his post-LBO compensation and equity return prospects;
  • delayed informing his board about the initial takeover proposal from the private equity firm;
  • provided the private equity firm with timing and informational advantages over other prospective bidders;
  • prevented the company’s financial advisor from reaching out to certain financial and strategic bidders;
  • made statements about the company’s prospects on an analyst call to manipulate the stock price downward and thereby facilitate negotiation of the buyout;
  • ran a “go shop” process characterized by an abbreviated timeline and access to limited information in part due to his unavailability for management presentations while on vacation; and
  • failed to disclose to the shareholders in advance of the merger vote that the company was outperforming market expectations—expectations that he had allegedly succeeded in tampering down to facilitate the sale process.

Meanwhile, the COO/CFO was allegedly “recklessly indifferent to” and facilitated some of these items and therefore the fiduciary duty claim against him survived the motion to dismiss as well.

Who bears the costs of these missteps?

The answer is the executive officers of the target company. In both Mindbody and Haley, some of the core claims for damages that survived the motions to dismiss were not against directors, but against officers, who, in contrast to directors, are not exculpated for actions taken in good faith. In Mindbody, Vice Chancellor McCormick used the gross negligence standard [5] (a less stringent standard than the “bad faith” standard necessary to establish a damages claim against a director) to assess the liability of the COO/CFO, as did Chancellor Bouchard in the recent Baker Hughes case. [6] Moreover, the Court of Chancery has acknowledged that there is an open question of whether a potentially lower standard than gross negligence may apply to determinations of an officer’s personal liability in connection with a process to sell control of the company. The courts have historically used the “range of reasonableness” standard to determine a director’s compliance with the Revlon duty to obtain the best price reasonably available when selling control of a company. [7] If this “range of reasonableness” standard were used to determine an officer’s personal liability (as opposed to the gross negligence standard), then the court may open the door to an even higher risk of unexculpated post-closing liability for officers. Plaintiffs’ lawyers are very focused right now on this risk for officers. Indeed, in a newly filed suit challenging a $3.5 billion LBO announced in December 2020, the plaintiff makes allegations similar to those in Mindbody and takes aim at the defendant founder expressly in his capacity as an officer of the target. [8]

How are the plaintiffs finding these bad facts and building their cases?

The answer is an aggressive use of the right of shareholders under Section 220 of the DGCL to access books and records of a Delaware corporation. The plaintiffs in Mindbody successfully used Section 220 demands to identify disconnects between what was in the board minutes and the defendant executives’ positions that they had been taking direction from a well-informed board in an exemplary manner. This may have been an easy task in Mindbody because, according to the court, there was an absence of any board minutes to support the defendants’ portrayals of the facts. Not only were there gaps in the minutes, it appears that the Section 220 demand, perhaps because of the weak minute-taking practices of the company, enabled the plaintiffs to get access to a load of informal electronic messages by the CEO/chairman and his team (including communications with bankers and private equity professionals) that contain what appear to be unhelpful expressions of his personal interests and that the court repeatedly quotes and finds persuasive. Back in 2007, then-Vice Chancellor Strine’s opinion in Netsmart stressed the importance of having a disciplined approach to board minutes, where they are finalized in advance of announcing a merger and are sufficiently detailed to refute allegations of lapses in compliance with fiduciary duties. [9] This advice is now doubly important given the use of Section 220 demands as a vehicle to build out complaints in M&A cases.

What is to be done?

In sum, directors and especially officers need to adhere to protocols for best practices in connection with any process to sell the company. This vigilance is arguably even more warranted when private equity bidders are on the scene. Moreover, documentation of this adherence in a solid set of board minutes is critical. The basics for these protocols include:

  • Officers should be updating and taking direction from the board, which should be involved and engaged regularly from the initial question of whether this is the right time to even explore a sale transaction.
  • All material relationships and interests of directors and officers relating to the sale process and the bidder universe need to be aired before the full board from the commencement of the process and regularly revisited, and appropriate steps need to be taken to neutralize these conflicts.
  • Due diligence processes and conveyance of information to bidders need to be supervised by advisors reporting to the board (and not by management acting on its own), and management should be chaperoned by these advisors in all of management’s communications with the bidders, especially private equity bidders.
  • Express permission from the board is necessary before any officer or director may commence communications with a bidder about personal post-closing arrangements and equity rollovers, the board must be informed of any deviations from this guideline, and these discussions should be sequenced to avoid any implication that they are part of the bargaining over the economics to shareholders.
  • Internal forecasts should be prepared by management and presented to and endorsed by the board no later than the determination to commence a sale process, rather than a choreography where the forecasts appear to be playing catch up to match the valuations underlying the bids.
  • Do not over-rely on a post-signing “go shop” as a means to satisfy the duty to obtain the best price reasonably available and, to the extent a go shop is part of the mix, be sure that the terms of the go shop do not render a superior proposal by a “go shop bidder” impractical.
  • When asking shareholders to take action in connection with a merger, such as participating in a tender offer or voting to adopt a merger agreement, all material nonpublic information, even if it comes to light after the mailing of the tender offer documentation or proxy statement, must be disclosed to the shareholders in advance of the expiration date for the tender offer or the shareholders meeting.

These take-aways are the same as they were over a decade ago. The burden is on the gatekeepers to start paying attention again.

Endnotes

1In re Netsmart Techs., Inc. S’holders Litig., 924 A.2d 171, 198 (Del. Ch. 2007) (internal quotation marks omitted).(go back)

2Ethan Klingsberg, The Need for Careful Choreography in LBOs, M&A Lawyer (Apr. 2007).(go back)

3235 A.3d 702 (Del. 2020).(go back)

42020 WL 5870084 (Del. Ch. Oct. 2, 2020).(go back)

5See In re Walt Disney Co. Deriv. Litig., 907 A.2d 693, 750 (Del. Ch. 2005), aff’d, 906 A.2d 27 (Del. 2006) (gross negligence requires a showing that the officer acted with “reckless indifference” or “without the bounds of reason”).(go back)

6In re Baker Hughes Inc. Merger Litig., 2020 WL 6281427, at *15 n.149 (Del. Ch. Oct. 27, 2020).(go back)

7Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34, 45 (Del. 1994).(go back)

8See Pullan v. Skonnard, C.A. No. 2021-0043-PAF, Compl. ¶ 101.(go back)

9See Netsmart, 924 A.2d at 187.(go back)

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