For private equity and other M&A transactions dependent on significant leverage, the credit crisis commenced in the summer of 2007. As credit dried up and challenging economic conditions spread to various sectors of the economy, many of the transactions struck but not closed prior to that time became unsustainable on their initial terms.
The subsequent turmoil surrounding pending deals caught up in the credit crisis gave rise to a number of high-profile disputes during the remainder of 2007 and throughout 2008, including in the proposed $52-billon purchase of BCE Inc. Many of these deals were either renegotiated or terminated altogether. Litigation related to these and other M&A transactions in this period in Canada and the United States required courts to scrutinize the actions of boards of directors and management of target companies and interpret the terms of many of these transactions. The resulting court decisions reflect a number of important legal developments and highlight some cautionary tales for boards of directors to keep in mind.
Those challenging an M&A transaction, whether it be shareholders, creditors, a competing bidder or other interested parties, will use myriad tactics. Irregularities and inaction on the part of a board have long provided a rich vein of material for claims that directors breached their fiduciary duties or did not implement appropriate procedures. Many decisions arising from the recent turmoil confirm this. Boards can avoid much of this with careful preparation and planning up front, and through the early adoption of appropriate processes. It will also be important to adequately document a board’s efforts so there is a clear record to demonstrate that the board of directors was properly informed and followed a fair process.
The decision of the Supreme Court of Canada in the BCE case confirms, as reported in our earlier article, that the fiduciary duties of directors in the context of a sale process differ somewhat between Canada and the United States — with a broader focus for directors in Canada than simply maximizing shareholder value. However, much of what can be learned from the recent US decisions with regard to the actions or inaction of directors is also applicable to Canadian boards.
So what can a board do in preparation for future M&A activity? From these Canadian and US decisions we can distil a number of best practices that boards can adopt to avoid similar traps in the future:
- Ensure that the board of directors performs its role. As reiterated in the BCE decision, the board of directors is ultimately responsible for acting in the best interests of the corporation. This involves directing and overseeing any sale process, as well as playing an active role in structuring the process and supervising management and any advisors.
- Take a proactive stance. As noted by the Delaware Chancery Court in Ryan v. Lyondell Chemical Co., a proactive response by the board and its direct involvement is critical when an early warning report of share ownership accumulation does come to light or an unsolicited offer is brought forward. Boards should act early and take advantage of the time available to make adequate preparations.
- Set guidelines for action. The board should set clear guidelines for action by board members, committees and management in addressing applicable aspects of, and responses to, possible developments related to a sale process.
- Allow adequate time for meetings. Adequate time should be allotted in scheduling board meetings for consideration of proposals in a sale process. The court in Ryan v. Lyondell was critical of a board that met only three times over no more than seven hours, questioning how it could have adequately addressed the transaction and available alternatives.
- Establish a special committee. Where appropriate, and as required, special committees of independent directors should be established with sufficient scope and mandate to ensure an appropriate sale process without reasonable risk of conflicts of interest. This was an issue in the recent US decision In re Lear Corp. Shareholder Litigation, and has been addressed by earlier Canadian decisions (such as Maple Leaf Foods v. Schneider and C.W. Holdings v. WIC Western International Communications).
- Implement processes with a critical eye. The directors should carefully consider how a particular process has been designed and carried out, as well as how any subsequent sale transaction is structured, so that the board can consider the impact of the decision on relevant stakeholders in the corporation under the particular circumstances. The court notes in the BCE decision that when considering what is in the best interests of the corporation, directors may, but are not required to, look at the interests of shareholders, employees, creditors, consumers, governments and the environment to inform their decision. Any sale process established should provide an opportunity to consider the interests of these constituent groups.
- Oversee management’s participation. Management’s involvement is generally important to an effective sale process. However, senior management should not conduct critical negotiations without the board’s involvement or without effective oversight from directors. A board should be cognizant of inherent conflicts that may arise given management’s interest in the continuation or termination of their employment and potential equity interest in the corporation going forward. As noted in the recent US decisions In re Topps Corp. Shareholder Litigation, In re Netsmart Technologies, Inc. Shareholders Litigation and Lear Corp. and a number of earlier Canadian examples, courts frown upon a process that allows management to negotiate material, financial and structuring terms of a transaction and conduct due diligence exercises without effective input from the board.
- Conduct regular strategic reviews. The board should review the corporation’s strategy on a periodic basis. This should include its position in the industry and an assessment of its readiness to deal with unsolicited offers. Boards will then be better prepared to react decisively to developments and to consider in advance fiduciary responsibilities in the context of a sale.
- Assess deal-protection terms. The directors should not assume that deal-protection terms can be treated as boilerplate. It can be dangerous to accept market norms for break fees and other terms without also considering the context and the impact.
- Keep careful records. The board should ensure a well-documented contemporaneous record of board deliberations is in place. This should include the periods leading up to and throughout the sale process. In some recent cases such as BCE, Ryan v. Lyondell and Lear, challenges by interested parties focus on perceived inadequacies of board action or inaction. A record of deliberations is often key evidence in refuting such claims. Minutes should be in sufficient detail so as to later allow directors to accurately recall the scope and substance of deliberations, as well as the information and any advice that directors relied upon.
- Canvass the whole market. Boards should not presuppose that one class of bidders or one group of bidders is not interested in the corporation — as the board concluded in respect of strategic investors in Netsmart. In this case, the court was critical of the board’s action given the company’s status as a microcap in the United States — the size of company that is far more common in Canada. Given our smaller domestic market, Canadian boards should be particularly careful in ensuring an adequate process is established to reasonably canvas all potential bidders.
- Conduct appropriate market checks. A board should carefully consider what pre-market checks and post-signing mechanisms for market checks — such as a go-shop provision — are required during the negotiation process, and the determination of agreed market checks should be documented accordingly.
- Carefully consider any single-bidder strategy. A single-bidder strategy requires particular care and preparation. Where a board has reliable evidence to evaluate the fairness of a sale transaction in relation to potential alternative transactions, it may approve a sale without conducting a formal auction or canvassing the market. The board should weigh the costs and benefits of such an approach and consider the weight and reliability of information available to the board.
- Rely only to an extent on financial advisors. There are limits to a board’s ability to reasonably rely upon financial advisors. As noted in Ryan v. Lyondell, a fairness opinion only speaks to the fairness of the transaction from a financial point of view. A fairness opinion does not speak to whether the proposal is the best transaction available to the corporation. Delivery of a fairness opinion is not a substitute for an appropriate market check.
- Know when to waive standstill agreements. Confidentiality and standstill agreements play an important role in helping boards manage an M&A process. However, boards should be cognizant of their fiduciary duties to the corporation once the process has resulted in an initial definitive agreement with a bidder. The Delaware Chancery Court in the recent Topps decision was critical of a board that did not waive standstill restrictions on other bidders once an agreement was signed. Before doing so, boards should be careful to ensure compliance with contractual commitments, as a definitive agreement may limit the ability of the company to waive a standstill agreement — as was addressed by the Ontario Superior Court of Justice in the Sunrise REIT case.
McCarthy Tétrault Notes:
Both the Canadian and the US decisions are consistent in that there is no specific, required process to be followed by the board. Neither is the board required to make a perfect decision. The courts will defer to the reasonable business judgement of the board provided the board has taken adequate and appropriate steps as outlined above.
Many transactions that were struck with great fanfare a short time ago have fallen by the wayside. It may be small solace but some of these court decisions (and other high-profile disputes that were ultimately settled) can provide a few guideposts for boards of directors to help them avoid some of the same errors and missteps in the future.
This report is drawn from a more detailed discussion of these and other issues arising in recent M&A case law in Canada and the United States in the paper presented by W. Ian Palm in January 2009 as Chair of the Osgoode Hall Law School CLE Conference on Private Equity Transactions.
In earlier issues we discussed some of the decisions referred to above (as well as a number of related decisions) in greater detail:
- Genesco v. Finish Line
- United Rentals v. Ram Holdings
- Clear Channel case
- Hexion Specialty Chemicals case
- Topps Co. and Lear