In any change-of-control business transaction, the decision by the target company’s board of directors to approve the deal is subject to heightened scrutiny by the courts. These days, virtually every M&A deal is sure to attract at least one strike suit challenging the board’s decision, so it is essential that the board’s decision-making process be robust and untainted by any conflicts of interest.
One way in which a board can insulate its decision-making process is to employ a special committee of independent, outside directors to evaluate and negotiate any potential sale. Although boards are not required by law to use special committees when brokering change of control transactions, Delaware courts have repeatedly held that the use of a special committee can be powerful evidence of a fair and adequate process. That is especially true where (i) the contemplated transaction is with a controlling stockholder or (ii) a majority of the directors are conflicted, two situations where courts will employ the even-more exacting “entire fairness” standard of review. As the Delaware Supreme Court recently noted, “the effective use of a properly functioning special committee of independent directors” is an “integral” part “of the best practices that are used to establish a fair dealing process.”
What constitutes a “properly functioning” special committee of independent directors? Beyond the threshold requirement that the committee members be independent – i.e., have no material relationships that might influence their business judgment – and have no disabling financial interest in the transaction, Delaware courts have asked the following questions, among others, to determine the effectiveness of a special committee:
- Who selected the committee members? Courts have criticized special committees whose members were selected by conflicted directors.
- How many directors are on the committee? Courts will place more trust in a multiple-member committee.
- What is the scope of the committee’s authority? Courts are more likely to credit the use of a special committee if the committee is given full decision-making authority regarding the transaction at issue, including the power to negotiate and to say “no” to the transaction.
- What were the committee’s resources? Courts have noted that special committees should have the power and resources to retain independent advisors, including legal and financial advisors.
Most importantly, to satisfy judicial scrutiny, a special committee must have a meaningful role in negotiating the terms of the transaction and be truly independent. Of course, there is no “one size fits all” method for insuring that every change of control transaction will pass judicial scrutiny, but by using a special committee of independent directors, boards are much more likely to defeat challenges to their deal-related business judgments.