The recent Delaware decisions in Orchard and MFW have been characterized by some as “gamechanging” for controlling shareholders and boards. Our view remains that the practical impact of these decisions will be limited. 1
At the same time, the recent Delaware decision in Rural Metro raises questions as to what its practical
impact will be on boards and investment bankers. The opinion reflects the Delaware courts‟ more detailed
focus in recent years on investment bankers‟ role in their capacity as advisors to boards in M&A
transactions. In this regard, we advise that investment banks review their current practices and
procedures to ensure that, as a substantive matter, they conform to existing standards for bankers
representing boards in a process designed to produce the best outcome for shareholders. In our view,
however, Rural Metro is in large part a product of the unusual facts in the case, and does not change
either the existing law relating to banker liability or the well established parameters for proper practice that
bankers have long followed.
Taken together, Orchard, MFW, and Rural Metro indicate that:
The Delaware courts continue to consider the totality of the actions of a target company‟s board
(or special committee) and financial advisor and the overall effect those actions have on the
transaction process.
The Delaware courts continue to emphasize longstanding themes: A special committee should be
independent. A financial advisor‟s conflicts of interests should be disclosed to and evaluated by
the special committee. A board should provide materially complete and accurate disclosure,
should act in the interest of the shareholders, and (with the financial advisor‟s expert advice and assistance) should seek to create a process that is designed to increase value for shareholders.
The board and the financial advisor each should be fully informed and fully engaged.
It is critical that each of the participants in a transaction adheres to well-established practices and
procedures. Further, it is evident that each of the participants has a vested interest in the other
participants also adhering to proper practices and procedures.
Price will continue to be a key focal point, and the “preponderant consideration”, in the courts‟
review of merger transactions.
In this memorandum, we discuss a number of observations and questions arising from these decisions.
The Practical Impact of the Decisions May Be More Limited than Some Expect
In Orchard and MFW, the Delaware courts established that a controlling shareholder going private
transaction will be subject to the business judgment standard of review (rather than the stricter entire
fairness standard) if, from the outset, the controlling shareholder subjects the transaction to the
unwaivable conditions that it be approved by a fully authorized and effectively functioning special
committee of independent directors and by a non-coerced fully informed majority-of-the-minority vote of
shareholders. While the business judgment and entire fairness standards of review are conceptually
quite different, in our view, based on MFW, it is highly likely that a process that meets all the standards
the decision establishes for application of the business judgment rule in this context would also pass
muster under the entire fairness standard.
MFW indicates that, whichever standard is applicable, the Court will focus on the special committee (and
investment banker) process, the proxy disclosure, and price. Although one would not typically expect the
Court to examine price when considering a transaction under a business judgment review (because of the
high degree of deference it extends to a board‟s business decisions), it is clear from MFW that the Court
will be looking at price as one of the most important factors in determining whether the special
committee‟s process was sufficient to permit review under the business judgment standard. The Court
states that allegations in the pleadings as to the insufficiency of price necessarily raise questions about
the sufficiency of the special committee‟s process and negotiations that would have to be examined by
the Court through discovery.
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As a practical matter, then, the primary impact of the decision may be
simply that it may become more possible to have a case dismissed after discovery rather than after a full
trial—not necessarily a meaningful change in terms of litigation cost, effort, or liability exposure.
In Rural Metro, the Court, in a trial on the merits, found that a financial advisor had liability for aiding and
abetting a breach of fiduciary duty by the target company‟s directors (even though the directors, who had
settled before trial, may have been exculpated from liability for the breach). The Court characterized
financial advisors as “gatekeepers” who must be incentivized to “provide sound advice, monitor clients,
and deter client wrongs”. While it is not possible to know how the Delaware courts may develop further
the views expressed in Rural Metro, the case stands out as having had an unusual set of facts that were
alleged.
3
Of course, efforts should be made to avoid every problematic factor that the Court ascribed to
the company‟s board and financial advisor; however, it is not clear that any one or more of those factors,
without the presence of many of the others, would necessarily have led the Court to the same result. The
decision may have the effect of encouraging plaintiffs to add investment bankers as defendants to M&A
shareholder litigation, in the hope that, through discovery, they will be able to find substantiation for an
aiding and abetting claim. However, there should be no more substantive legal basis for claims against
bankers now than in the past. Moreover, plaintiffs are not likely to continue to add investment bankers as
defendants if the claims for aiding and abetting liability are regularly dismissed—as we would expect will
generally be the result except in unusual fact situations.
Issues for Controlling Shareholders
Decision whether to include the MFW-prescribed procedural protections. Controlling
shareholders will have a threshold decision whether to structure a going private proposal with
both of the procedural protections described in MFW, in the hope of obtaining a business
judgment standard of review, or whether to proceed without both of these procedural protections
and face the entire fairness standard of review.
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The controlling shareholder will need to make
this choice based on its evaluation of the following factors: the likelihood of obtaining the minority
shareholder approval; the balance between the cost in terms of a higher price that may have to
be paid in a process that includes the procedural protections for the minority shareholders (and is
reviewed under the business judgment standard) as compared to the cost that may arise in
shareholder litigation arising out of a process that does not include the protections (and is
reviewed under entire fairness); and the extent of the differences, as a practical matter, between
a litigation conducted under a business judgment standard that has satisfied all of the parameters
set forth by the Court in MFW as compared to one conducted under an entire fairness standard.
As discussed above, in our view, it is likely that there will not be a significant practical difference in the Court‟s substantive review of a transaction, whether it is determining if the business
judgment rule can apply, or it is conducting a review under entire fairness.
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Unanswered questions that will be critical when making the decision whether to include
the MFW-prescribed procedural protections.
o Will the controlling shareholder be precluded (completely, or for some period of time)
from proceeding with the transaction if either of the procedural protections is
abandoned by the controlling shareholder during the process? If the controlling
shareholder structures the transaction to include both of the procedural protections, what are
the consequences if it later decides to proceed with the transaction without one or both of the
protections (for example in the event that the minority shareholder vote appears to be
unobtainable or in fact is not obtained)? As MFW requires that the conditions be “nonwaivable”, presumably there is at least a period of time that the controlling shareholder would
have to wait between abandoning a proposed transaction that included the condition and
making a new proposal; however, there is no guidance in the opinion on this point. Will the
controlling shareholder be precluded from proceeding with the transaction (and, if so, for how
long), or will the transaction then simply be subject to an entire fairness standard of review?
In the former case, there would be a real price to pay in choosing to include the procedural
protections and then being unable to complete a deal on that basis -- the controlling
shareholder would not be able to proceed with a transaction (at least for some time,
presumably). By contrast, in the latter case there would be nothing to lose in choosing to
include the procedural protections and then abandoning them — at worst, the controlling
shareholder would end up under an entire fairness standard (where it would have been
anyway had it not included the procedural protections), or could commence a tender offer for
the minority shares (that would not be subject to a fairness standard so long the Court‟s
guidelines in the Cox Communications decision are followed).
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o Will the Court expect that the price the special committee negotiates with the
controlling shareholder will replicate (or come close to) third-party value? The premise
underlying the Court‟s decision in MFW is that, by putting the prescribed procedural
protections in place from the outset, the controlling shareholder “irrevocably and publicly
disables itself from using its control… [and] the controlled merger then acquires the
shareholder-protective characteristics of third-party, arm‟s length mergers, which [have
always been] reviewed under the business judgment standard.” The Court emphasizes that
the purpose of the dual procedural protections is to ensure that “the controlling stockholder
[does] not dictate the terms of the transaction and that the [special] committee exercise[s] real bargaining power „at an arm‟s length‟.” Further, the Court states that, when both of the
dual procedural protections are in place, they “replicat[e] the arm‟s-length merger steps of the
DGCL….” The Court reiterates the longstanding view of the Delaware courts that price is the
“preponderant consideration” in the courts‟ review of merger transactions—and further states
that “the underlying purposes of the dual protection merger… and the entire fairness standard
of review converge and are fulfilled at the same critical point: price (emphasis in original).”
Given the Court‟s essential premise that the dual protections create a transaction that is the
functional equivalent of an arm‟s length third party transaction, the Court‟s supporting
rationale that third party mergers have always been subject to the business judgment
standard of review, and the Court‟s continued emphasis on price as the predominant factor in
evaluating a transaction, does the Court expect the dual protection process to result in a price
that equals (or approximates) third-party value for the shareholders?
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Notably, Delaware law does not require that a controlling shareholder share its control
premium with the minority shareholders in a transaction; and the MFW opinion does not refer
to a “third-party price”, but only to a “fair price”, to be negotiated by the special committee in a
process with the dual protections in place. However, the Court‟s underlying rationale and
discussion raise the question whether the Court will find that, although controlling
shareholders have no legal obligation to share the control premium with the minority
shareholders, the business judgment review will be applied only when the price negotiated by
the special committee is within the range of values that could be expected to be achieved in a
third-party transaction.
Mutual interest of all participants in each participant’s compliance with proper procedure.
It is important to note that, even if the controlling shareholder structures the transaction to include
the two MFW procedural protections, and then obtains both the special committee board and
minority shareholder approvals, the transaction still may end up being reviewed under the entire
fairness standard if the special committee or investment banker is found to have failed to adhere
to the standards for their actions that are necessary for the business judgment rule to apply. The
procedural protections achieve the business judgment standard of review only if the special
committee is truly independent, fully authorized, and effectively functioning (and note that, for the
special committee to be considered effectively functioning, it is critical that the financial advisor on
whom it relies is itself effectively functioning, and that the board has evaluated any conflicts the
advisor may have); and only if the minority shareholder vote is fully informed (meaning that the
company‟s disclosure was materially complete and accurate). Thus, each participant has an
interest in all of the other participants adhering to proper procedures in performing their
respective roles to ensure the overall integrity and fairness of the process.
Ultimate liability is the controlling shareholder’s. Each of the controlling shareholder, the
special committee, and the financial advisor has multiple incentives to perform properly (for
ethical, reputational, deal completion, and liability purposes). At the end of the day, however, it is
the controlling shareholder that, in a completed transaction, likely will bear the financial cost of
noncompliance with proper procedure -- either directly, in the form of damages to shareholders for the controlling shareholder‟s noncomplying actions, or (absent a basis for finding an indemnity
obligation inapplicable) indirectly, in the form of indemnification to the company‟s directors,
officers, and investment bankers.
Issues for Special Committees
Continued focus on board process. Even though the Orchard and MFW decisions address
procedures to be effected by a controlling shareholder hoping to achieve a business judgment
standard of review, the courts‟ emphasis is still on the target company‟s board process. MFW
indicates that, when the Court considers whether the business judgment standard is available, if
shareholder-plaintiffs plead “a conceivable set of facts” that call into question the sufficiency of
the price paid in the transaction, it will inherently raise issues about the sufficiency of the board‟s
special committee process. Similarly, any credible issues raised about the proxy disclosures will
call into question the sufficiency of the minority shareholder vote. Accordingly, just as adherence
by the target company board to proper procedure has been critical in the context of an entire
fairness review by the courts, it is clear that it will continue to be a focus of the Court‟s
consideration when determining whether the business judgment rule standard will apply.
Price negotiations and “just say no”. The premise on which the dual procedural protections of
special committee and minority shareholder approvals is based is that they will result in a
controlling shareholder transaction becoming the functional equivalent of a third-party arm‟s
length transaction because the controlling shareholder will have disabled itself from standing on
both sides of the transaction. A critical factor in evaluating whether these protections will be a
proxy for a third-party result will be in the price a special committee is able to negotiate. An
important consideration in this regard will be whether the price negotiated-- by an independent
special committee that has the negotiating leverage of board authorization to “just say no” to the
controlling shareholder and “to make that decision stick”-- is in the range of prices that would
have been expected based on customary valuation analyses, including discounted cash flow,
trading value, comparable transactions, and the like.
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Unanswered questions that will be critical for special committees. There are a number of as
yet unanswered questions that will be critical for special committees (and boards) in this context.
For example, it is unclear whether the special committee‟s authority to “just say no” to the
controlling shareholder must include the right to take action, such as establishing a shareholder
rights plan, to prevent the controlling shareholder from accumulating shares in the market that
increase its ownership and leverage in furtherance of the transaction. It is also unclear for how
long the committee‟s saying “no” must be, or can be, effective. Further, it is unclear what the
special committee needs to require from the controlling shareholder in terms of the controlling
shareholder‟s commitment to proceed with the transaction only through the committee and with
the minority shareholder vote. As discussed above, it is unclear whether, after saying no to the
controlling shareholder, the controlling shareholder is subject to a cooling-off period. Indemnity issue. It also should be noted that directors and officers of the target company, as
well as the target company‟s financial advisors, are typically entitled to indemnification from the
company in the event they are found to have liability in connection with a transaction. In Rural
Metro, the target company‟s financial performance declined after the merger, and it declared
bankruptcy. Accordingly, the directors who were found by the Court to have breached their duty
to shareholders could have borne liability (had they not settled and been removed from the case
before the end of the trial and had they been found to have breached their duty of loyalty).
Similarly, the investment bankers, who were found liable for aiding and abetting the directors‟
breaches, will not have the benefit of the indemnification from the company they bargained for in
connection with their engagement by the company.
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Of course, it is also an unanswered question
whether the banker‟s actions would be deemed to have fallen within the typical exclusions from
indemnification for actions that constitute bad faith, willful misconduct, and the like. To address
the risk of a target company‟s post-merger bankruptcy, companies may want to consider whether,
in the context of an acquisition that is completed, and where the acquired company is a
subsidiary of the acquirer, the standard indemnification provisions should be changed to obligate
the acquirer to backstop the target company‟s indemnification obligations to its directors.
Financial advisors may want to consider adding this protection in the indemnification provisions of
their engagement letters. Further, companies could consider whether the acquirer‟s
indemnification guarantee should be expanded to extend to directors‟ breaches of loyalty (for
which the target company itself typically would not have an indemnity obligation).
Issues for Investment Bankers
Delaware courts continue the recent detailed focus on investment bankers in their role as
financial advisors to boards in M&A transactions. In recent years, the courts have shown an
increased inclination to examine in detail the actions taken by investment bankers when
representing target boards -- and especially the issues that arise from bankers‟ conflicts of
interest. This focus heightens for bankers the need to ensure that they have in place, and are
scrupulously following, practices and procedures that are intended to ensure that the bankers act
in accordance with best practices, and that they disclose conflicts of interest to the board (or
special committee). The courts have not, however, changed the legal basis for liability of
bankers. While Rural Metro characterized bankers as “gatekeepers”, there is no suggestion in
the opinion that bankers have a direct relationship with or legal obligation to any person or entity
other than the target board (or special committee). While it is not possible to know with certainty
how the jurisprudence may develop after Rural Metro, there is no indication in the opinion that
bankers will have any liability in this context other than for aiding and abetting directors‟ breaches
of duty to shareholders.
No significant change in standards for how bankers should function. The decision does not
change the practices and procedures that investment bankers have long followed in advising in
M&A processes. The Court‟s focus in Rural Metro was on what it found to be the financial
advisor‟s conflicts of interest, manifested, according to the Court‟s view of the facts, primarily by
its strenuous efforts to provide financing to potential buyers and to leverage its engagement to obtain a financing role in another matter— leading the Court to determine that the advisor was
acting primarily in its own interest throughout the process. This judgment was compounded by a
set of highly unusual factors relating to the special committee‟s process, the bid process, and the
financial advisor‟s valuation work. The overall context in which the Court considered the banker‟s
and the target company‟s directors‟ actions was a product of the confluence of all of these rather
unusual factors. In that regard, it should be kept in mind that courts will be influenced by the
totality of the investment banker‟s (and the board‟s) actions, and the overall effect their actions
have on the process.
Need to proactively disclose conflicts of interest. Recent cases highlight the need for
investment bankers proactively to identify and disclose to the target company‟s board (or special
committee) any conflicts of interest they may have (including any possible objective to provide
financing for the transaction or other related transactions).
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Rural Metro confirms that providing
buy-side financing in the context of a sell-side assignment will be viewed as appropriate only
under limited circumstances— that is, where the board of the target company finds that such
financing provides a benefit to the company by affirmatively helping the sale process (for
example, because of difficulties with otherwise arranging financing), and after disclosure to the
board of the benefits and risks to the target company of its financial advisor providing the
financing (including the potential conflicts of interest). Further, if the target company authorizes
the investment banker to provide buy-side financing, the company must subject the banker‟s
financing efforts to ongoing oversight and direction by the company.
Need to evaluate strategic alternatives. These decisions indicate that, in many circumstances,
investment bankers should be authorized by the board to, and for analytical purposes should,
consider and analyze a variety of strategic alternatives in addition to a sale transaction. A variety
of valuation analyses should be presented to the board. Orchard underscores that, in a
controlling shareholder going private transaction where the controlling shareholder has stated that
it would not agree to any other transaction or a sale of its shares, strategic alternatives should be
explored and valued as if the controlling shareholder were willing to sell its shares or approve
alternative transactions. The value of any possible transaction also should be compared with the
company‟s long-term value assuming it remained independent.
Guidelines:
The Delaware courts likely will be reviewing for some time the extent to which the template they have
created in Orchard and MFW actually works in practice to meet their goal of replicating third-party arm‟s
length transactions in controlling shareholder going private transactions—and the courts may refine the
new standards if they are not meeting that objective. It remains to be seen whether the Rural Metro
decision (which did not involve a control shareholder transaction) will affect litigation against investment
bankers -- but no new standards of conduct for bankers were established by the case. Taken together,
these cases reinforce that meticulous adherence to well established practices designed to ensure the
integrity of the process for a transaction will continue to be critical.
