Management Buy Outs (“MBOs”) became popular in the United States in the late eighties and early nineties. Though MBOs have many potential benefits, they also bring with them difficulties as they may place the board and management of a corporation in positions of potential conflicts of interest.
It is important to be clear on what exactly a MBO is and how it differs from other going private transactions such as leveraged buyouts (“LBOs”) or a regular sale of the corporation to an arm’s length third party. A MBO is a transaction in which the ownership of a business passes out of its existing ownership to its managers in whole or in part. Commonly, instead of the usual two parties (the seller and the buyer), there will normally be three, namely the seller, the managers and the person or institution providing the bulk of the finance for the purchase. The defining criterion of a MBO is the “who”; specifically that it is the managers of the corporation who acquire a meaningful ownership interest in the business through the purchase.
On the other hand, a LBO is defined by the “how”, specifically that the buyer acquires a corporation through a secured loan with assets of the acquired corporation charged as collateral. The buyer in a LBO can involve management (i.e. a MBO is often a sub-species of a LBO), but this does not have to be the case. Similarly, while many MBOs are leveraged, they do not necessarily need to be.
The key difference then between a MBO and a regular sale process is that while in a regular sale process the management is independent of the buyer, and its interests are generally aligned with those of the corporation, in a MBO the management is aligned with the buyer and as such its interests will diverge from those of the corporation, putting management in a clear conflict of interest.
Fiduciary Duties of Directors and Officers
Canadian corporate statues and common law impose upon the directors and officers of the corporation a fiduciary duty to act honestly and in good faith with a view to the best interests of the corporation, and require them to act in an impartial, disinterested manner, making decisions only for rational business purposes. This duty of loyalty recognizes that the directors and officers are the stewards of the corporation and are required to place the interests of the corporation above their own interests. This includes an obligation to act, to the extent possible, free of any conflict of interest. Where a transaction involves a perceived or actual conflict of interest, the duties imposed on the directors are heightened. Any such transaction is likely to undergo rigorous scrutiny from the public, regulatory authorities and shareholders. If ever challenged in court, any such transaction will likely be considered in light of the efforts taken by the directors and officers to insulate the decision-making process from actual or potential conflicts of interest. Such conflict may arise in situations where, for example, certain directors or officers appear on both sides of a transaction, as in a MBO.
Conflict of Interest in MBOs
Most sales processes involve a real or perceived conflict of interest for management of a corporation, who may for example seek to entrench themselves. In a MBO, the corporation’s directors or officers who are members of the management buyout group (the “Management Buyers”) have a more acute and clear conflict of interest which puts far greater strain on their abilities to fulfil their fiduciary duties. The interests of the Management Buyers conflict with those of the corporation, because the Management Buyers have personal interests in acquiring the corporation for less, while it is in the best interests of the corporation that the corporation is either not sold, or is sold for more.
Intensifying this conflict is the fact that the Management Buyers are uniquely well placed to negotiate a lower price for the corporation due to their insider knowledge and control of the day to day management of the corporation. As a result, there is almost always a lingering suspicion that any top executives who are Management Buyers are timing the buyout to pay a discounted price or are otherwise taking advantage of their unique knowledge and influence.
This also puts the Management Buyers in a precarious position insofar as their personal liability as officers is concerned, because the Management Buyers are, by virtue of this conflict, far less likely to be accorded the benefits of the “business judgement rule” by a court. In normal business circumstances the decisions made by management are given deference by courts, regardless of whether they eventually result in success or failure for the corporation, as long as they are taken in good faith and based on a diligent, well informed evaluation process. Where the management has put itself in a clear conflict of interest, the decisions they take are far less likely to receive the protection of this deference and the Court may approach them with great scepticism. For example, where management makes a mis-step in the business, a court will likely be less deferential if there is a reasonable basis for suspecting that management is deliberately trying to reduce their purchase price as buyers.
Another concern is that the Management Buyers may be able to force a sale of the corporation where a standalone plan is in fact more desirable, or prevent other potential buyers from offering a competing bid. Even if the Management Buyers do not take active steps to prevent other alternatives being considered or to dissuade other bidders, the very fact that there is a MBO proposal can serve to deter consideration of other alternatives or keep other bidders away.
Finally, even directors who are independent of the Management Buyers, may be influenced into approving the MBO, simply because they feel there is no choice and that if the board says no they will be left not only without a deal, but with very dissatisfied management or may lose key members of management.
The first step which the Management Buyers must take to avoid a breach of their fiduciary duties is to disclose to the board of directors their intention to pursue the MBO as early in the process as reasonably possible. The earlier that this intention is disclosed, the earlier the board can take steps in order to limit the ill effects of the conflict of interest. Failure to disclose the intention early enough has been at the core of breach of fiduciary duty complaints several well-known shareholder lawsuits contesting MBOs. Though there is no clear line as to when disclosure is necessary, it is preferable that disclosure is made before the Management Buyers take any concrete action in pursuit of a MBO. No disclosure of the corporation’s confidential information should be made by the Management Buyers to third parties (such as financiers) without the express consent of a special committee of the board.
The board should also seek to set up a special committee of independent directors at the very early stages of the MBO. Unlike those directors who are Management Buyers, the independent directors are not in a conflict of interest. The role of the committee is to evaluate the corporation’s alternatives (which may include no sale at all), run any sales process, evaluate and negotiate the resulting offers and oversee any valuation which may be required.
Throughout a MBO, the special committee should typically be empowered to fulfill a number of functions:
- in the initial stages, evaluate the proposal of the Management Buyers as well as determine whether to consent to the Management Buyers’ use of confidential information;
- determine whether and when to remove any Management Buyers as officers or to operate as an executive committee running the day to day affairs of the company alongside management;
- supervise the work of management during this time to confirm that the conflict of interest of the Management Buyers is not affecting their decision-making relating to the day to day running of the corporation (it is advisable, that during this period the Management Buyers do not take any major business decisions without the approval of the special committee); and
- independently negotiate the transaction and obtain the advice of experienced independent professional advisors, in particular the analysis and advice of independent financial advisors, such as an independent valuation or fairness opinion.
The advice given by the financial advisor in respect of a proposed transaction should be given under the direction of the special committee, which should also ensure that the advisor has been provided with all relevant information it requires to accomplish its work. Independent legal advisers are also required; often the corporation’s traditional counsel for the special committee will not be seen as sufficiently independent if they have worked with the Management Buyers over a lengthy period of time.
The fairness of a MBO may also be enhanced by the presence of other bidders or at least a widely marketed effort to attract bidders. Opening the sale of the corporation to the market at large, such as through an auction, will likely assist in establishing the fair market price for the corporation. It is important, however, that such an auction is conducted under the oversight of the special committee and that other bidders are given similar opportunity and information as the Management Buyers in order to achieve competitive bidding.
Though the mitigation measures described above can combat to some extent the tension placed on the fiduciary duty of the Management Buyers as a result of the conflict of interest, they cannot relieve this tension permanently. As the MBO process progresses, the conflict of interest will become more acute. The Management Buyers need to be attentive to the changing demands on their loyalty throughout the process. If at any point one of the Management Buyers feels they can no longer fulfil their fiduciary duties as director and officer of the corporation, even with the mitigation measures described above in place, that Management Buyer must immediately step down from their role in the corporation.
Special thanks to Anna Pogosjan for her assistance in preparing this article.