Small cap public companies should not be lulled into complacency by the recent dearth of activity on the mergers and acquisition front. Indeed, small cap companies, and particularly those whose market capitalization has declined significantly as a result of the general economic downturn, remain likely targets of takeover activity, whether this interest is welcome or not. Dwindling market capitalization makes these companies more vulnerable targets as economic health and confidence returns to the market. Directors should consider the following issues and recent developments as they evaluate how to best position their companies to respond to takeover attempts.
Directors can adopt a wide variety of measures aimed at reducing the attractiveness of their company for a hostile takeover. These measures include the following:
- Shareholder rights plan (“poison pill”).
- Staggered board of directors.
- Supermajority voting requirements for certain business combinations and other corporate actions, such as removal of directors.
- Restrictions on shareholder authority to call special meetings.
- “Blank check” preferred stock.
- Requiring advance notice of director nominations and other shareholder proposals to be considered as part of a company’s proxy materials.
- Change of control provisions in key corporate financing and other agreements (“poison puts”).
A number of these protective provisions require a stockholder vote to implement. The most effective, although not foolproof, preventative measure is the poison pill because it typically does not require stockholder action to implement, and because it forces a potentially hostile acquirer to negotiate with the target’s board of directors or abandon the hostile takeover. The pill’s effectiveness can be enhanced by combining it with other preventative measures, such as having a staggered board.
Ordinarily, a board’s decision to adopt a poison pill, or other preventative measures, will be viewed deferentially by the courts under the business judgment rule, and a court will presume that the directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. However, preventative measures that are adopted in response to a specific takeover threat face increased scrutiny under the so-called Unocal standard, under which the board must establish that its actions are reasonable in relation to the threat posed.
The strategy of waiting for a specific takeover threat to emerge before adopting a poison pill is not particularly well suited to small cap companies. Two critical warning signs of a potential takeover attempt—an antitrust filing under the Hart Scott-Rodino Act ($65 million deal value threshold) and a filing of a Schedule 13D (reflecting ownership of 5% of the company’s outstanding stock)—may not occur until after a potential acquirer has accumulated a meaningful ownership interest in the company. As a result, a small cap company is more apt to be taken by surprise by a takeover attempt. As always, a countervailing consideration in taking a more proactive approach, especially with respect to adopting a poison pill, is that it may trigger a negative reaction from shareholders, as well as activist measures such as a shareholder proposal to remove anti-takeover measures.
In light of these concerns, directors of small cap companies should assess the effectiveness of their existing preventative measures against hostile takeovers, and determine whether it is necessary to adopt additional preventative measures in the current economic environment, or at least be prepared and ready to implement them in the event of an unsolicited offer. For example, it may be advisable to have a poison pill prepared but not implemented unless and until a hostile offer is received.
Directors’ Duties in Evaluating Potential Transaction
A decision by a board or committee of a board composed of disinterested and independent directors to either reject or accept an offer for the company is fraught with the possibility of a potential lawsuit. Shareholders that are dissatisfied by the board’s decision may file a lawsuit alleging that the directors breached their duty of care or loyalty or failed to act in good faith. Directors of most companies are shielded from personal liability for unintentional breaches of the duty of care by exculpatory provisions in the corporation’s charter. Recent case-law also suggests that disinterested directors have a wide range of protection from personal liability for allegations that the directors acted in bad faith when deciding whether to reject or accept an offer to sell the company.
- Exculpation: Delaware, and some other states, have important statutory provisions that can be used to shield directors from personal liability. Under Delaware General Corporation Law, a corporation can adopt a charter provision that exculpates directors from personal liability for unintentional breaches of the duty of care. Under this provision, a plaintiff’s allegation for an unintentional breach of the duty of care will likely be dismissed before trial.
Although a significant source of protection, exculpatory provisions do not shield directors from all grounds for personal liability. Delaware law does not permit exculpation of personal liability for breaches of the duty of loyalty, and specifically precludes exculpation for failure to act in good faith. Plaintiffs regularly take advantage of these exceptions by alleging a director’s actions breached the duty of loyalty and were taken in bad faith.
- Rejecting an Offer: Ordinarily, a decision by the board to reject an offer is protected by the business judgment rule, under which directors are presumed to have acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. To negate the presumption, a plaintiff must plead facts sufficient to support a reasonable inference that the directors did not act in good faith pursuant to a legitimate corporate interest or were not well informed about the offer. An allegation that the director is motivated solely by the desire to remain in control is not enough, without other facts that the director acted disloyally, to rebut this presumption. If the plaintiff fails to meet this burden, the case could be dismissed so long as the decision can be attributed to a rational business purpose.
Ordinarily, the business judgment rule can shield directors from potential lawsuits based on their decision to reject an offer. This protection, however, is not foolproof. In Gantler v. Stephens, the Delaware Supreme Court found that the plaintiff plead sufficient facts to negate the presumption that the majority of directors acted in good faith when rejecting a merger offer and deciding to reclassify the common shares and go private. In this case, no apparent legitimate corporate interest was served by rejecting the offer, and some of the directors had other significant financial interests that would be severely impacted by the loss of control of the board. Furthermore, one of the board members (a member of management) inexplicably attempted to sabotage the due diligence process by not promptly providing material in response to the acquirer’s request.
The ramifications of this decision are uncertain, but it will probably not broaden the range of circumstances under which disinterested and independent directors can be found liable for rejecting a merger offer. So long as the board is well informed about the offer and is acting on the basis of a legitimate corporate interest, then its decision should receive deference under the business judgment rule.
- Accepting an Offer: When accepting a cash offer and conducting negotiations for the sale of the company, directors must act in accordance with their Revlon duty, which is the duty to maximize price for shareholders during the sale of a company. This duty arises when the board decides to sell the company—on its own initiative or in response to an unsolicited offer. The Revlon duty is not a separate duty from other fiduciary duties, but requires that the board perform its fiduciary duties in the service of maximizing the sales price of the enterprise.
A decision by the Delaware Supreme Court, Lyondell Chemical Co v. Ryan, makes it increasingly unlikely that a board of disinterested and independent directors will be found personally liable for not acting in good faith in connection with their Revlon duties. In Lyondell, the directors were presented with an extremely favorable offer, but it was set to expire after one week. During the week, the board met several times, solicited and sought advice of financial and legal advisors, instructed the CEO to attempt to negotiate better terms and considered the prospects of getting a higher bid. At the end of the week, Lyondell accepted the acquiror’s offer and entered into a merger agreement. The plaintiff alleged that board acted in bad faith for not taking sufficient steps to get the best price for the shareholders, but the court held that the board’s actions, although arguably imperfect attempts to ensure the best price, did not amount to bad faith in connection with the Revlon duty.
According to Lyondell, the Revlon duty does not require the board to take any specific steps to ensure the best possible price for the company. A board’s actions will only be considered in bad faith if the board knowingly fails to attempt to achieve the best possible sales price for the company.
This decision sets an extremely high bar for plaintiff’s proving a board acted in bad faith in connection with the Revlon duty. It is currently unclear what actions constitute failure to attempt to obtain the best sales price, but reasonable steps to obtain the best price, such as testing the market for other offers, obtaining an independent valuation or a fairness opinion, will certainly increase the likelihood that a disinterested and independent board does not act in bad faith in connection with its Revlon duty.
This decision, however, does not foreclose the possibility that directors can be found personally liable for unintentionally breaching the duty of care in connection with their attempts to satisfy the Revlon duty. Directors, however, can be protected from this possibility if the corporation has an exculpation provision that shields the directors from unintentional breaches of the duty of care.
In the current economy, small cap companies should consider whether they are prepared for the possibility of a friendly or hostile takeover bid. To prepare for this possibility, directors should evaluate whether there are effective measures in place to ensure that the board can maintain an appropriate level of control in a sale process and whether their corporate charter has an exculpatory provision. If an offer is received, whether friendly or hostile, directors should be mindful of their fiduciary duties and only act for the best interests of the corporation and shareholders.