The Delaware Chancery Court’s recent decision in In re Netsmart Technologies, Inc. Shareholders Lit., Del. Ch., C.A. No. 2563, Strine, V.C. should be considered by in-house counsel and corporate directors contemplating a sale of their company, particularly those who are planning a formal auction process. The decision thrusts into question the reliability of those “best practices” that are familiar to all M&A practitioners and that boards rely on to demonstrate the fairness to stockholders of the sales process. At issue in Netsmart were two procedural safeguards that are staples of modern cash-out transactions: (1) the formation of a special committee of independent directors to evaluate the transaction and manage confl icts of interest; and (2) the inclusion of deal-protection terms presumed to facilitate a post-signing market check of the negotiated deal terms. Ultimately, the case warns against the rote adoption of generic, court-sanctioned procedural safeguards as a short-cut to undertaking a more deliberative, specifi cally-tailored approach to the design of a sales process.
The Netsmart decision demonstrates that, in order to satisfy the heightened fi duciary duties applicable in cash-out sales, boards of directors should:
- Undertake a deliberate, thoughtful assessment of the particular risks and other considerations specifi c to their transaction and design a sales process around those features;
- Establish procedures for considering and approving sale transactions that make sense in light of the company’s business, its market dynamics, the history of discussions regarding a potential sale, its prospects in the absence of the sale and other concerns that can affect the sale process;
- Adopt procedural safeguards that provide meaningful protection under the circumstances, since ineffective measures will undermine the integrity of the sales process;
- Enforce the chosen procedures carefully, with particular focus on preventing interested parties from infl uencing the decision-making process; and
- Keep detailed and current records of meetings at which important decisions are made, including the rationale behind the decisions.
The remainder of this alert summarizes the key holdings and fi ndings of the Court in Netsmart and provides practice points that can be learned from the decision.
The key holdings of the Court in Netsmart include the following:
- Netsmart’s board of directors and special committee had no reliable basis on which to conclude that an auction process that targeted only private-equity bidders and excluded strategic bidders would yield the best deal for the company’s shareholders given Netsmart’s circumstances.
- Plaintiff stockholders demonstrated a reasonable probability that the decision-making process behind the design of the Netsmart auction was not logically sound or reasonable under the circumstances, and therefore the board had breached its Revlon duty – “the fi duciary duty to undertake reasonable efforts to secure the highest price realistically achievable given the market for the company” in the context of an auction.
- Projections used by the company’s fi nancial advisors in performing a discounted cash fl ow valuation in support of its fairness opinion should have been disclosed in the proxy materials soliciting stockholder approval of the transaction.
- The Court granted a preliminary injunction against the completion of the merger pending Netsmart’s amendment of its proxy materials to include the fi nancial projections and disclose additional information concerning the board’s decision not to canvass strategic buyers during the auction process.
Signifi cant Facts and Findings
- The Special Committee Was Not Properly Formed or Adequately Shielded from Management Infl uence. Since management of an auctioned company is generally more likely to have continuing roles with the company if it is sold to a private equity rather than a strategic bidder, management is often presumed to have an inherent motivation to infl uence the sales process. Not uncommon for sales of this sort, Netsmart’s board decided to form a special committee of independent directors that excluded members of management, including Netsmart’s CEO (who was also a board member). However, this special committee was formed after management had already decided to pursue the basic strategy of conducting a rapid auction to identify a private-equity buyer.
Also, the Court found that the CEO collaborated closely with the special committee, was often present at meetings when key strategic decisions were discussed, and infl uenced aspects of the process that should have been controlled by the special committee. Netsmart management, for instance, managed the due diligence process notwithstanding their obvious and direct interest in the outcome (the CEO and other offi cers were in fact negotiating the terms of their post-closing employment agreements on a parallel track to the negotiation of the acquisition agreement). Close involvement of management with the activities of the board and the special committee tainted the sales process – notwithstanding the Court’s acknowledgement that there was no evidence of an adverse impact on the auction and its recognition that no member of management (including the CEO) would receive an actual windfall or excessive payments in the deal. The Court found the process to be defective because the board failed to take into account that management was inherently motivated to tilt the process in favor of private-equity buyers.
- Lax Deal Protection Terms Do Not Facilitate Meaningful Post-Signing Market Checks in Less Active Markets. The resulting agreement to sell Netsmart to a private-equity buyer featured relatively modest deal-protection terms – including a 3% break-up fee, a “window shop” provision that allowed the board to entertain unsolicited bids by other fi rms, and a “fi duciary out” clause that allowed the board to recommend against the merger if it received a superior proposal. Negotiating these features into the deal, the defendants argued, would provide confi rmation that the negotiated deal offered the best price available for Netsmart’s stockholders or else would identify a strategic buyer willing to pay more. This implicit, post-signing market check, defendants argued, made it unnecessary to canvass strategic buyers during the auction process. However, in light of the market dynamics faced by Netsmart – a thinly traded, micro-cap company with minimal analyst coverage – the Court determined that these lax deal terms could not be expected to have a meaningful impact on the sale process. Accordingly, the Court concluded that the board’s decision to rely upon a post-signing market check, rather than undertake any canvassing of strategic buyers during the auction process, was unreasonable.
Lessons for Practitioners
One noteworthy feature of Netsmart is the absence of a “smoking gun” – the Court does not focus on any single glaring defect in the sales process. The Court considered in turn the arguments offered by the board in defense of its decision to exclude strategic buyers and refuted each of them in a thorough and highly critical analysis. Accordingly, one of the main points to take away from Netsmart is simply the extent of the scrutiny and lack of deference with which the Delaware courts are currently reviewing a board’s decision-making process when the duty to obtain the best price for stockholders is triggered. Additionally, the following practice points, although not novel, are worth reiterating in light of the Netsmart decision:
1. Plan a Meaningful, Carefully Designed Sales Process and Stick to It.
Netsmart reminds practitioners that procedural safeguards and protective devices – no matter how often they have been sanctioned by courts and used by practitioners in other transactions – may provide little protection, if applied incorrectly or under the wrong conditions, particularly when the logic of a board’s decision is subject to the heightened judicial scrutiny applied in buy out transactions. It is critical for the directors to take the time to establish and clearly articulate a formal sales process at the outset. If a special committee will be formed, the board should make sure it has a clear mandate and adequate authority and resources to achieve its goals (possibly including the ability to retain its own fi nancial advisors and legal counsel). Counsel should ensure that all participants understand and adhere to the procedures and restrictions until the transaction is completed. The failure of one or more board or special committee members to comply with the established procedural safeguards can undermine the integrity of the entire sales process. At a minimum, it raises red fl ags for a court or opposing counsel to focus on in litigation.
2. No Single Blueprint for All Deals.
Netsmart teaches that Delaware courts may challenge a board’s decision-making process in a Revlon context even if the board adopts the usual grab bag of deal protection provisions. The Court’s message is clear: a board of directors that ignores the specifi c market dynamics, potential confl icts of interest and other particular risks and issues that confront the company, is not undertaking “reasonable efforts” to maximize stockholders’ returns. Any board should orient its decision making to the company’s particular circumstances and the specifi c context of the deal, rather than rely upon the protective devices that courts may have found to be appropriate under distinguishable circumstances.
3. Focus on Quality, Not Quantity, of Procedural Safeguards.
There is often a temptation for boards to adopt procedural safeguards that provide little or no meaningful protection (or confi rmation) of the sale process, under the theory that the inclusion of an ineffective protective device “could not hurt” and, if anything, bolsters the appearance of a reasonably designed sales process. Netsmart demonstrates that inclusion of ineffective procedural safeguards can actually have adverse consequences for the board. By highlighting a fl aw in the sales process, an ineffective procedural safeguard can draw attention away from the more meaningful features of a sales process and tip the scales against a board under a standard of review that has verylittle “tolerance for slack,” in the words of the Court.
4. Look Out for Inappropriate Infl uence of Management and Other Interested Parties.
Directors should be wary of even the appearance of confl icts, particularly structural confl icts (such as those involving management) inherent in the private-equity buy out context. Accordingly, it is important that safeguards intended to shield the independent decision makers from undue management infl uence are applied thoughtfully, correctly and without exception. If the procedural safeguards do not effectively protect against management’s active involvement in the board’s decision- making process, a court may fi nd the entire sales process compromised or fl awed in its design.
5. Maintain Detailed and Current Records of Key Decisions.
The lack of support in the corporate records for the rationale (as asserted during litigation) behind important board decisions contributed to the Court’s conclusion that the sales process was defective. Specifi cally, the Court pointed out that key decisions were made at “informal” meetings of the board and that board minutes and special committee minutes in some cases were prepared months after the meetings were held.
Additionally, the minutes of certain meetings, at which key strategic decisions were made, did not include a meaningful description of the factors considered by the Board. Netsmart reminds practitioners of the importance of good recordkeeping and proper adherence to corporate formalities and highlights the risks inherent in relying on broad, generic descriptions of deliberations where the record should instead refl ect a careful, deliberate and reasonable decision-making process.
6. Encourage Frequent Communication Between Directors and Counsel.
The main lessons learned from the Netsmart decision are not likely to make the job of in-house counsel any easier. While it is one thing to say that a board needs to exercise care in its deliberations to come up with a logical sales process; or that management and other interested parties should be prevented from exercising undue infl uence over a special committee – the fact of the matter is, any advice that slows a deal down or makes a closing less certain is rarely appreciated. Ultimately, it is simpler to construct a sale process if counsel has an opportunity to spot problems at the beginning, rather than during the fi nal days before the closing.
Although Netsmart involved a fl awed special committee process and inappropriate reliance on an implicit, post-signing market check, the larger message of this decision is not limited to a particular protective device, but rather to the manner in which boards adopt and implement protective devices as part of a formal sales process. There is, unfortunately, no universal safe harbor for boards in the context of a cash-out transaction. Rote adherence to court-sanctioned procedural safeguards is likely to draw intense scrutiny and skepticism from a Court that has clearly become frustrated by the pervasive use of shortcuts to meaningful deliberation.