In a case said to involve "a microcosm of a current dynamic in the mergers and acquisitions market," the Delaware Court of Chancery found that the board of directors (the "Board") of Netsmart Technologies, Inc. ("Netsmart") focused the sale of the company too narrowly on private equity buyers and did not adequately canvass strategic buyers.
Companies, and in particular their boards of directors and special committees, engaged in conducting a sales process or auction involving a merger or disposition, should consider the following points from Netsmart:
- A limited auction process may be grounds for a finding of a breach of the board's fiduciary duties. In Netsmart, the Court found that management steered the sale process toward private equity buyers. The Court dismissed arguments that private equity buyers could close transactions more quickly than strategic buyers, and that confidentiality in discussions with strategic buyers could not be as easily maintained;
- As special committees are traditionally used to reduce conflicts of interest, care needs to be taken to maintain processes independent from management. In Netsmart, the special committee's close involvement with management, management's control over the due diligence process and the special committee's retention of the same financial advisor used by management invited shareholder suspicion; and
- There is no single blueprint for conducting a sales process or auction. In Netsmart, the Court cautioned against using a large-cap approach to micro-cap deals, as different market dynamics must be accounted for.
Netsmart is a NASDAQ-listed supplier of enterprise software to behavioural health and human services organizations. Netsmart entered into a merger agreement (the "Merger Agreement") with two private equity firms whereby Netsmart shareholders would receive $16.50 per share, and Netsmart would subsequently be taken private (the "Merger").
After Netsmart's acquisition in October 2005 of its largest direct competitor, potential private equity buyers initiated dialogue with Netsmart management. In May 2006, Netsmart management recommended that the Board consider a sale of the company to a private equity firm.
Netsmart management previously had contact with potential strategic buyers; however, the Court described this contact as "sporadic" and "isolated." Netsmart management stated that Netsmart's market niche was too small on a stand-alone basis to make Netsmart attractive to larger health services software providers; however, the Court pointed out that management's contacts with potential strategic acquirors occurred prior to Netsmart's acquisition in October 2005, when Netsmart was a smaller and less consistently profitable entity.
In July 2006, the Board formed a Special Committee of independent directors; however, as stated by the Court, the Special Committee "conducted itself in a manner that invites stockholder suspicion." The Special Committee maintained close ties with management and allowed Netsmart's CEO to participate in its meetings, and it also retained the same financial advisor as was used by Netsmart management. Furthermore, Netsmart's due diligence process was handled by management, with little involvement from the Special Committee. With the Special Committee's recommendation, the Board approved the Merger.
The plaintiff shareholders challenged the Merger and argued that the failure of the Board to canvass potential strategic buyers led to a flawed sale process, and sought a preliminary injunction to enjoin the Merger. The plaintiffs argued that the apparent private equity-friendly sale process was motivated by management's desire to continue in their positions and retain an equity stake in Netsmart.
The Board argued that the preference for private equity purchasers was born out of the desire to maintain greater confidentiality during the sale process and to close the deal quickly, and that this preference was within their bounds of discretion. The Board also argued that any interested strategic purchaser could launch a hostile bid for Netsmart, and that the failure of a higher bid to materialize confirmed that the Merger was the best offer available.
Ruling of the Court
The Court held that the plaintiffs had established:
(i) that the Board did not have a reasonable basis for excluding strategic buyers from the sale process; and
(ii) a probability that the proxy materials related to the Merger were materially incomplete for the failure to disclose certain expected future cash flow projections.
As there was no higher bid pending, the Court chose not to grant a broad injunction against the Merger, as such a ruling could have resulted in the bidders exercising their rights to terminate the Merger Agreement. The Court instead imposed a temporary injunction on the Merger until the proxy materials were amended to include further information on the expected future cash flow projections, as well a "fuller, more balanced" description of the Board's actions in canvassing potential strategic buyers.