Under Delaware law, a board of directors entering into a change of control transaction involving the sale of a company must secure the best value reasonably attainable for the company's stockholders. This "reasonableness" standard applied in change of control transactions is significantly more severe than the traditional business judgment rule that merely requires a rationality review. The two components of this reasonableness test are: (1) a judicial review of the adequacy of the decision making process used by the directors, including the information on which the directors relied; and (2) a judicial review of the reasonableness of the board's action in light of the then-existing circumstances. A recent decision by the Delaware Chancery Court demonstrates that a board that does not employ traditional value maximization tools, such as an auction, a broad market check or a go-shop provision, must possess a detailed knowledge of the company's business for a court to determine it acted reasonably.
The Delaware Chancery Court declined to enjoin a change of control merger and found that notwithstanding the board's somewhat flawed process and failure to include traditional value maximization tools, the board's actions combined with its "impeccable knowledge" of the target company's business were enough to support the challenged transaction. Vice Chancellor Noble noted that ""[a]lthough the Board's decision-making process was not a model to be followed," their decision making was adequate because unlike most directors who simply direct a company, the facts showed that the directors in this case managed the company and that "this is one of those few boards that possess an impeccable knowledge of the company's business." The board members in question, some of whom were affiliated with private equity firms while others had been involved since the company's founding, shopped the company to two legitimate strategic buyers and received a limited financial analysis. Despite the lack of more traditional value maximization tools, the court accepted the argument that, "in light of the Board's impeccable knowledge, the Board knew whether financial buyers would be interested in [the company]" and therefore a more thorough shopping of the company was unnecessary.
Turning to the second prong of the analysis, the court noted that small companies like the one in this case do not "get a pass" simply because they are small, but when a small company is managed by a board with the kind of knowledge as the board here, the court would consider the company's size in determining what was reasonable and appropriate. The sixteen-person group of the board and the company's current executive officers held more than two-thirds of the corporation's outstanding capital stock, so it was clear that the directors actually had more to lose – or gain – from the challenged merger than any other group of stockholders. There was every incentive to ensure that the merger did in fact maximize stockholder value. The court also noted that, given the small size of the company, it was questionable whether the company would want to undertake an extensive market check or seek a fairness opinion. However, "[t]he fact that a company is small, however, does not modify core fiduciary duties and would not seem to alter the analysis, unless its board [is] well-versed in the company's business." So, once again, the knowledge of the board in this case was a critical factor in the finding that its actions were reasonable.
The plaintiffs also challenged certain defensive measures included by the board in the merger agreement, noting that the merger contained a no-solicitation clause and that it did not have a "fiduciary out." Under Delaware law, to justify the use of these defensive measures a board must: (1) demonstrate that there were reasonable grounds for believing that a danger to corporate policy and effectiveness exists; and (2) that the defensive measures were reasonable in relation to the perceived threat. In this case, the court found that there were few potential buyers for the company, and there was a legitimate fear that business could seriously decline in the near future, which meant that the timing of the merger was important.
Given that the plaintiffs did not dispute these facts, the court concluded that a legitimate threat did exist. As to the reasonable relation of the defensive measures, the court noted that there was no stockholder voting agreement as part of the merger, and the merger was not a "fait accompli." The fact that stockholder approval was virtually guaranteed given the board's ownership of over two-thirds of the company's stock did not alter the court's opinion. The court also expressly noted that the lack of a fiduciary out did not automatically require that the merger be enjoined, especially in light of the fact that no superior offer had emerged and because the board retained the ability to cancel the merger if stockholder approval was not obtained by the business day after signing the merger. Ultimately, the court concluded that the merger "neither forced a transaction on the shareholders, nor deprived them of the right to receive alternative offers," and as a result, the defensive measures were acceptable.
This case demonstrates that traditional value maximizing tools may not always be necessary when a board considers a merger proposal, provided that the board is sufficiently familiar with a company's business and conducts a reasonable investigation into alternative options under the circumstances. The court repeatedly emphasized the "impeccable knowledge" of the board in this case and the fact that the directors in effect managed the company. If a board chooses to forego more traditional value maximizing tools, it should ensure that it has done so based on the extensive knowledge of a company's business in order to prevent claims that the board breached its fiduciary duties. This case further demonstrates the highly factual analysis that underpins a challenge to a merger, and that fiduciary outs are not a prerequisite under Delaware law, at least in instances where there has been stockholder approval and no superior offer has emerged.