In re Netsmart Technologies, Inc. Shareholders Litigation, No. 2563-VCS (Mar. 14, 2007)
The obligations of a board of directors in the discharge of their fiduciary duties are especially significant when the company is for sale. While there is no definitive set of procedures required, directors must take reasonable steps to maximize shareholder value and must take care to place the interests of the company and all of its stockholders over any divergent personal interests of the directors or management. The Delaware Court of Chancery's recent decision in In re Netsmart Technologies, Inc. S'holders. Litig. provides important insight into several aspects of a director's duties in the sale context in what the decision described as a "microcosm of a current dynamic in the mergers and acquisitions market." In a March 14, 2007, opinion, Vice Chancellor Strine ruled that although the stockholder plaintiffs had established a likelihood of succeeding on the merits of some of their claims of wrongdoing in connection with a proposed sale of the company to private equity buyers, the stockholder vote on the sale could go forward after supplemental disclosure of both the Court's opinion and certain financial projections. In so ruling, the Vice Chancellor specifically addressed (i) the viability of limiting a market canvas to private equity buyers only; (ii) the need to disclose financial projections relied upon by financial advisors; and (iii) best practices for a special committee in connection with a proposed sale. Before proceeding to a discussion of each of these aspects of the Court's opinion, a brief review of the background facts is helpful.
Netsmart wasa supplier of enterprise software for behavioral health organizations that had been profitable for several years following its 1992 formation. Netsmart's growth was achieved primarily by its acquisition of competing firms in its niche market - a strategy capped off by its October 2005 purchase of its largest competitor, CMHC Systems, Inc. ("CMHC"). Despite its growth and success in its niche market, sporadic attempts by Netsmart to attract larger IT companies as potential suitors had proved unfruitful. Shortly after the CMHC acquisition was completed, however, private equity buyers expressed interest in acquiring Netsmart, and in May 2006, Netsmart's management recommended to the board that it consider selling the company to a private equity firm rather than pursue deals with strategic buyers. After first agreeing to adopt the private equity strategy, Netsmart's board formed a special committee to protect the interests of the company's non-management stockholders.
The special committee pressed forward with pursuing the private equity strategy adopted by the board, continuing to collaborate with management in the process. The special committee retained William Blair & Co., L.L.C. ("William Blair") as its financial advisors for a potential sale. William Blair prepared a host of financial projections, including DCF (discounted cash flow) analyses, to assist the special committee in evaluating the economic merits of any transaction. Analyses in hand, the special committee attempted to generate interest on the part of seven private equity firms, but received bids from only four. The special committee ultimately recommended approval of a merger agreement with a private equity firm known as Insight Venture Partners ("Insight"). The merger agreement with Insight contained several standard provisions, including provisions for the continued employment of the Netsmart management team and options designed to encourage management to maximize Netsmart's value. The merger agreement also contained a three percent breakup fee and a "window-shop" provision that prohibited the board from shopping the company, but allowed the board to consider superior proposals. Shortly after the merger agreement was signed, the company publicly announced the merger.
The special committee met about a month after that announcement and approved formal minutes for 10 of its meetings dating back more than four months. The same day, Netsmart filed its preliminary proxy with the SEC, which was later mailed to stockholders. The company set April 5, 2007, as the date for the special meeting of the stockholders to vote on the merger. As of the time of the Court's March 14 decision, no topping bidder had emerged.
The stockholder plaintiffs in Netsmart filed a complaint seeking a preliminary injunction to prevent the consummation of the merger. The plaintiffs claimed that the financially underwhelming merger was the result of an inadequate sale process that did not properly include a canvass of potential strategic buyers, allegedly because management only wanted a private equity deal that would allow them to continue in office. The plaintiffs also alleged that the merger process was plagued by incomplete and misleading disclosures, including the omission of information about Netsmart's prospects if it were to remain independent, i.e., the best estimates of the company's future standalone performance. The defendants argued that they acted reasonably in balancing the cost and confidentiality-based benefits of a canvass involving only a limited private equity market versus the risks of missing out on other potential buyers. The defendants also argued that the lack of any better offer in more than three months after announcing the merger confirmed that the Insight deal was in fact the best available.
Court of Chancery Decision
In its decision on the preliminary injunction, the Court of Chancery found that the plaintiffs established a reasonable probability of success on the Revlon claim that the directors had no reliable basis for determining that the Insight deal was the best available, because they failed to explore strategic buyers. In so finding, the Court explained that a decade of "sporadic chats" by management about possible deals with strategic buyers were not "the stuff of a reliable market check." Instead, having embarked upon a cash sale, "it was incumbent upon the board to make a reasonable effort to maximize the return to Netsmart's investors." The Court also explained that, under the circumstances, the board's efforts could and should have included a "salesmanship effort" to proactively reach out to targeted strategic buyers rather than to rest on a reactive "window-shop" market check that merely allowed for but did not actively solicit topping bids. The Court noted that since the board considered only the private equity deals presented by management, strategic buyers might perceive that management was interested only in doing a deal in which they continued as management, thus deterring potential bidders. In the end, the evidence as to the validity of the search process was "more indicative of an after-the-fact justification for a decision already made, than of a genuine and reasonably-informed evaluation of whether a targeted search might bear fruit."
Turning to the plaintiffs' disclosure allegations, the Court found a likelihood of success on one of the three claims pled. The proxy materials circulated to stockholders in advance of the stockholder vote on the proposed sale disclosed various valuation analyses done by the board's financial advisor, William Blair. One valuation analysis that was not disclosed, however, was a DCF valuation performed by William Blair based on a set of projections running to 2011 created with the help of management. Those projections took into account the company's acquisition of CMHC and provided the "best estimate of the company's future cash flows." The same DCF analysis was used by the company as part of its formal process of soliciting interested buyers. The Court explained that when asked to decide whether to "accept cash now in exchange for forsaking an interest in future cash flows," a Netsmart stockholder would certainly want to know the "best estimate of what those future cash flows would be." The Court further explained that the need for such information is especially significant when "key managers will remain as executives and receive options" after the sale. An important suggestion of the Court's opinion is that all valuation analyses must be disclosed in a cash-out transaction: "[W]hen a banker's endorsement of the fairness of a transaction is touted to shareholders, the valuation methods used to arrive at that opinion as well as the key inputs and range of ultimate values generated by those analyses must also be fairly disclosed."
In addition to its Revlon and disclosure holdings, the Court also commented on the special committee's practices in the sale process. The Court specifically cautioned that special committees could and should have taken a more active role in the due diligence process rather than completely delegating that duty to management, especially because management may have been uniquely biased in favor of a deal. The Court also frowned on both a lack of minutes for key board meetings relating to the sale and the en masse approval of other board meeting minutes after the fact, noting that the "omnibus consideration of meeting minutes is, to state the obvious, not confidence-inspiring."
The Court ultimately declined to enjoin the stockholder vote on the sale of Netsmart because of the risk that an aggressive injunction might result in Insight walking away from a potentially attractive transaction. The Court instead ordered supplemental disclosures in the form of the missing DCF analysis and a copy of the Court's decision, which the Court felt would allow stockholders to make an informed decision for themselves.
The Netsmart decision is important for directors considering going-private transactions. The decision makes clear that although a pure private equity strategy that allows management to remain intact may be enough, a broader market check that includes strategic buyers is the better approach in most cases. Where stockholders are being asked to decide whether to accept cash rather than retain a long-term stake in a company, the Court's decision also makes clear that a complete set of financial projections considered by the board and its financial advisors in opining on the fairness of the deal should be disclosed. Finally, the Court's decision is a signal that special committees should be actively involved in all aspects of the sale process, including due diligence, and that the special committee should regularly engage in contemporaneously-documented meetings to review their findings and make recommendations going forward.