Special Committee Midyear Report

This issue of the Debevoise & Plimpton Special Committee Report surveys corporate transactions announced during the first half of 2024 that used special committees to manage conflicts, and key Delaware judicial decisions rendered during this period that relate to issues relevant to the use of special committees.

Focusing on Advisor Conflicts

The first half of 2024 saw a sharp focus of the Delaware courts on financial and legal advisor conflicts. Three of the six Delaware judicial decisions involving special committees summarized in this Report turned on such conflicts. In two of those decisions, the Delaware Supreme Court overturned—on the basis of inadequate disclosure of advisor conflicts—lower court rulings dismissing breach of fiduciary duty claims arising from controller take-privates. In the third decision, the Court of Chancery declined to dismiss breach of fiduciary duty claims against the controller and directors of a target company relating to undisclosed conflicts of the financial advisors to the company and to a special committee of the board, and upheld aiding and abetting claims against those advisors on the basis of engagement letters that allegedly aligned their interests with the controller rather than the stockholders as a whole. This trio of recent decisions indicates the need for a high level of vigilance by special committee members and their advisors in identifying and disclosing conflicts in order to realize the benefits of special committee and majority-of-the-minority vote arrangements, as well as the risk to advisors of fee constructs that may be seen to create improper incentives.

Each of these three decisions is more fully summarized in the Recent Special Committee Decisions section of this Report. The discussion below article focuses on the specific financial advisor conflicts at issue in those three cases and the disclosure deficiencies that resulted in potential exposure to the target controllers, directors and bankers. We also offer some best practices to reduce the likelihood of such claims in future transactions.

TerraForm Power

The first decision arose from the take-private of TerraForm Power by its 62% stockholder. 1 The transaction was structured to satisfy the requirements of Kahn v. M&F Worldwide Corp. (MFW), namely, approval by a special committee of the TerraForm board and a majority-of-theminority stockholder vote. As a result of these protections, the Court of Chancery dismissed breach of fiduciary duty claims brought by stockholders against the controller and the TerraForm directors. The Delaware Supreme Court reversed on the ground that the stockholder vote was uninformed as a result of inadequate disclosure of conflicts of the special committee’s advisors.

The special committee’s financial advisor and its affiliates held over $470 million of investments in private equity funds managed by affiliates of the controller. Although the proxy statement disclosed that the financial advisor “may have” investments in private equity funds managed by the controller, the company took the view that the aggregate amount of those investments— representing only about one-tenth of one percent of the total assets managed by the advisor— was too small to be material. The Supreme Court disagreed, holding that the materiality of the investment must be determined not in comparison to the overall size of the advisor’s investment portfolio but rather from the perspective of the stockholders asked to vote on the transaction. The Court found it reasonably conceivable that a stockholder would consider $470 million to be material in assessing the advisor’s objectivity. Moreover, the Court criticized as misleading the statement that the advisor “may have” investments in funds managed by the controller since the advisor in fact did have such investments.

The Court of Chancery had also dismissed claims relating to undisclosed conflicts of the special committee’s legal advisor, consisting of three prior and one concurrent representation of the controller in unrelated matters. The Supreme Court, again holding that the materiality of such conflicts must be measured from the point of view of a stockholder deciding how to vote, determined that those conflicts, and in particular the concurrent representation, were material facts that should have been disclosed.

Inovalon Holdings

The second decision arose from the sale of Inovalon Holdings to a private equity firm in a transaction in which the target’s controller rolled over a portion of his equity interest.2 As with TerraForm, the transaction was approved by a special committee of independent directors and a majority-of-the-minority stockholder vote. On that basis the Court of Chancery dismissed breach of fiduciary duty claims brought against Inovalon’s controller and directors. Again, the Delaware Supreme Court overturned the trial court decision because of inadequate disclosure of financial advisor conflicts.

The proxy statement disclosed various prior engagements of the special committee’s financial advisor with the buyer and its co-investors, including the fees it had earned on those engagements. However, it did not disclose a concurrent sell-side engagement with the buyer or a concurrent placement agent engagement with a co-investor. The proxy statement instead stated that the advisor may in the future provide financial advisory or other services to the company, the buyer and their affiliates. The Supreme Court held that this statement was misleading because when the proxy statement was issued, the advisor already had such conflicting engagements.

The proxy statement also disclosed that the company’s financial advisor had previous and concurrent engagements with the company, the buyer, and various of the co-investors, and that over the prior two years the financial advisor had received approximately $15.2 million in fees from the buyer. However, the proxy statement did not disclose the amount of fees the advisor had received over the prior two years from the buyer’s co-investors, or the amount of fees it expected to earn from its concurrent engagements—only that it had received, and would receive, “customary compensation” in respect of those engagements. The Supreme Court found this disclosure to be inadequate. It held that the failure to disclose expected fees on current engagements “prevented stockholders from contextualizing and evaluating [the advisor]’s concurrent conflicts of interest” and found it reasonably conceivable that additional disclosure “would have altered the total mix of information available to stockholders.” The Court contrasted the $15.2 million of disclosed fees paid to the advisor by the buyer with the nearly $400 million of undisclosed fees paid to the advisor by the co-investors. It found the overall disclosure to be misleading because it could have led stockholders to believe that the undisclosed fees paid by co-investors were of a similar magnitude to the disclosed fees paid by the buyer.

Foundation Building Materials

The third decision arose from the sale of Foundation Building Materials, which was controlled by a private equity fund that had a Tax Receivable Agreement (TRA) with the company. 3 The TRA entitled the controller to a termination payment upon a change of control of the company. The Foundation board formed a special committee to address the conflict created by the TRA. The company and the special committee each hired a financial advisor. In both cases, the financial advisor’s engagement letter provided for a success fee payable upon the closing of the transaction, the amount of which was determined based on the sum of the deal price plus the TRA change of control payment.

The information statement provided to stockholders following the controller’s approval of the transaction by written consent disclosed the fees payable to the two financial advisors but did not disclose the manner in which they were calculated. The Court of Chancery held that the fact that the advisors’ fees were based, in part, on the TRA change of control payment, rather than solely on consideration payable to the stockholders for their equity interests, created a conflict of interest for the advisors, and that the failure to disclose that conflict supported a claim for breach of fiduciary duty against the company’s directors. In addition, while the information statement described the relationship between the company and its financial advisor and legal counsel, it did not describe the much more extensive relationship that each of them had to the private equity fund that controlled the company. This too was found by the court to support breach of duty claims against the company’s directors.

More critically from the point of view of the financial advisors, the Court of Chancery upheld aiding and abetting claims against both advisors. An aiding and abetting claim against an agent requires its “knowing participation” in the fiduciary breach of the principal. Here, the court found that the structure of the advisors’ success fees aligned their interests with those of the controller, and that this alignment was sufficient to support the aiding and abetting claim. In fact, the court questioned the propriety of the special committee’s advisor receiving any success fee at all: “It is one thing to pay contingent compensation to the financial advisor charged with securing the best deal reasonably available. It is another thing to pay contingent compensation to the financial advisor who is supposed to be willing to tell the special committee that the deal should not happen. Because of that different role, a special committee’s financial advisor should not receive contingent compensation.”

Lessons and Recommendations

There are a number of lessons that can be taken from this trio of decisions.

It’s not the conflict, it’s the disclosure. In the Inovalon decision, the Delaware Supreme Court cited prior holdings to the effect that “there is no hard and fast rule that requires financial advisors to always disclose the specific amount of their fees from a counterparty in a transaction. Rather, the materiality standard governs whether a financial advisor’s exact amount of fees collected from a counterparty to a transaction requires disclosure.”4 Nonetheless, these decisions indicate that the bar for materiality is lower than parties may have thought. Rather than trying to identify the line between material and not material, advisors may be better off focusing on the Supreme Court’s statements in TerraForm as to “the need for transparency in [a] special committee’s reliance on its advisors” and the requirement of “full disclosure of investment banker compensation and potential conflicts.”

Compliance with Securities and Exchange Commission requirements is not sufficient. Item of 1015 of the SEC’s Regulation M-A requires an advisor that delivers a report or opinion (other than a legal opinion) to a public company involved in an M&A transaction to disclose various things about the engagement, including material relationships that existed in the past two years between the advisor and its affiliates and the public company and its affiliates and the amount of compensation received or to be received as a result of those relationships. Issuers and their counsel take great care to comply with this requirement, and such compliance is policed by the SEC, which in reviewing proposed disclosure statements sometimes requests even more detailed information. However, satisfying the SEC’s requirements may not be sufficient to satisfy the Delaware courts that directors have satisfied their fiduciary duty of disclosure under Delaware law, or that a majority-of-the-minority vote was “fully informed” for purposes of obtaining the benefit of business judgment rule review under MFW.

What goes into an advisory fee calculation may be more important than what comes out. The amount of the fees payable to the financial advisors to Foundation Building Materials and the special committee of its board were disclosed, as were the other relationships between those firms and the controller and buyer. However, the Supreme Court held that in light of the specific conflicts at issue, this was not sufficient to meet Delaware’s requirement for “full and fair disclosure regarding financial advisor conflicts and compensation arrangements,” and that the inputs to the fee calculation should have also been disclosed. The Court considered the fact that the advisors’ financial incentives were tied to the conflict between the controller and the minority stockholders to be more relevant to the minority than the amount of the payment itself. Although the circumstances here may be unusual, issuers and advisers should consider what incentives may be created by various fee structures and whether those incentives should be specifically disclosed.

It’s fine to put things in context, so long as it is the context of the stockholders. One tenth of one percent may not be much, but $470 million is a lot. What is immaterial to a large financial institution may be deemed to be quite material by an individual stockholder. In the context of a proxy statement, it is usually the point of view of the latter that matters.

Don’t wish on may or might. Both Supreme Court decisions found fault with disclosures about investments an advisor may have made or engagements it might undertake, where those events in fact actually occurred or currently existed. Proxy statement disclosures in the subjunctive mood invite skepticism and risk being found to be inherently misleading.

Concurrent conflicts may trump prior ones. In its TerraForm decision, the Supreme Court held that three undisclosed recent but completed engagements of the legal advisor to the special committee by the controller may not have been, standing alone, sufficient to state a disclosure claim, but the firm’s one undisclosed concurrent engagement with the controller tipped the balance. In its Inovalon decision, the Court also seemed more concerned with the financial advisors’ concurrent engagements with related parties than its past engagements. In each case, the Court held that such relationships, while not necessarily disabling, were material and should have been disclosed.

Make sure advisory incentives are properly aligned. For advisors, the most concerning element of these decisions is the holding of the Court of Chancery in Foundation Building Materials declining to dismiss aiding and abetting claims against the financial advisors to the target and the special committee based on conflicts stemming from the fee construct in the advisors’ engagement letters. The court did not find it relevant that the term creating the conflict represented only five percent of the fees that the advisors earned from the transaction. Financial advisors and their counsel should review carefully the financial incentives created by the advisor’s engagement letters and seek to maximize, to the extent possible, alignment with interests of the advisory client.

Be cautious about incentive arrangements in special committee engagements. Using a special committee to address conflicts in a proposed transaction involving conflicted fiduciaries is effective only if the special committee has “the power to say no” to the transaction. Foundation Building Materials is not the first Delaware decision to have questioned the compensation arrangements that give the persons on whom the committee relies for financial advice a significant economic incentive to support the transaction.5 While clients are often reluctant to commit to paying large fees in the absence of any transaction, special committees and their advisors should consider carefully the potential risks as well as rewards of success fee arrangements.

Link to the full report can be found here. 

1City of Dearborn Police & Fire Revised Retirement System (Chapter 23), et al. v. Brookfield Asset Management Inc., et al., No. 241, 2023 (Del. Mar. 25, 2024).(go back)

2City of Sarasota Firefighters’ Pension Fund, et al. v. Inovalon Holdings, Inc., No. 305, 2023 (Del. May 1, 2024).(go back)

3Firefighters’ Pension System of the City of Kansas City, Missouri Trust v. Foundation Building Materials, Inc. et al., C.A. No. 2022-0466-JTL (Del. Ch. May 31, 2024).(go back)

4Inovalon, pp. 43-44.(go back)

5See In re Tele-Commc’ns, Inc. S’holders Litig., 2005 WL 3642727 (Del. Ch. Dec. 21, 2006) (“[T]he contingent compensation of the financial advisor, of roughly $40 million creates a serious issue of material fact, as to whether [the advisor] (and [it]s legal counsel) could provide independent advice to the Special Committee.”).(go back)