Lessons for boards of directors today
A recent Delaware Chancery Court decision acts as another reminder of the risks to deal consummation posed by serious conflicts of interest of management and financial advisers, as well as the critical role played by a board of directors in managing such conflicts of interest.
In Re El Paso Corporation Shareholder Litigation(1) addressed the conflicts arising in the sale of publicly held corporation El Paso Corporation to Kinder Morgan.
Chancellor Strine noted a number of conflicts of interest raised by this transaction, including:
- The chief executive officer (CEO) of El Paso – the key negotiator for El Paso in the merger transaction approved by the board – had disclosed to the El Paso board neither his interest in developing a bid with others in his management team to buy from Kinder Morgan the El Paso exploration and production (E&P) business which the El Paso board had proposed to spin off, nor his contacts to Kinder Morgan's CEO about this proposed separate transaction;
- The El Paso board relied on advice from Goldman Sachs, knowing that Goldman owned 19% of Kinder Morgan (a $4 billion investment) and controlled two Kinder Morgan board seats; and
The El Paso board engaged a second investment bank, Morgan Stanley, in light of Goldman's known conflicts, however:
- Goldman Sachs continued to advise on strategic alternatives and advised on the El Paso proposed spinoff of the E&P business, including valuation analyses used in evaluating the Kinder Morgan deal;
- Goldman Sachs intervened in the negotiation of the terms of the second bank's engagement to assure that Morgan Stanley received compensation only if El Paso chose the Kinder Morgan deal; and
- the lead Goldman Sachs banker did not disclose that he personally owned approximately $340,000 of Kinder Morgan stock.
Strine noted that the record showed a number of debatable negotiating and tactical decisions which nonetheless, in the absence of a conflict of interest, would not have raised concerns. Given that the CEO and Goldman Sachs, the board's long-time and trusted financial adviser, had serious conflicts of interest, the decisions by the CEO and Goldman Sachs were viewed as potentially "compromised by the conflicting financial incentives of these key players".
Although Strine declined to grant a preliminary injunction, he found that the plaintiffs had a reasonable likelihood of success on the merits in proving a breach of the loyalty duty, thus potentially exposing the defendants to claims for damages post-closing. The decision not to enjoin was based on the chancellor's conclusion that the stockholders had a choice to turn down the merger and his unwillingness to remove a premium bid from the stockholders, given that no alternative bid existed.
The record provided some examples of the types of decision made by the negotiators, which were subject to serious second-guessing in light of the CEO and Goldman Sachs conflicts:
- Kinder Morgan made what appeared to be an attempt at a pre-emptive bid for El Paso following El Paso's announcement of an intent to sell the E&P business and then threatened to go public but, instead of calling Kinder Morgan's bluff and permitting a public auction to develop, El Paso's CEO entered into negotiations with Kinder Morgan.
- The El Paso board knew, in failing to shop the deal, that Kinder Morgan was attempting to prevent competition for El Paso in a normal sales process, and that there could be a number of bidders for the E&P business or the balance of the El Paso business but no likely bidders for El Paso as a whole, but did not contact alternative buyers for either of the businesses to see if there was any significant interest or more attractive bids.
- Kinder Morgan then backed off its price, asserting that it had relied on aggressive analyst projections. El Paso did not call its bluff, settling for a lower price without any significant pushback.
- The parties negotiated a no-shop clause that prevented El Paso from entertaining any proposal for the E&P business, while continuing as an independent company, despite the fact that this sale and continuation of the balance of El Paso was the previously announced board strategy and the only realistic alternative to the transaction with Kinder Morgan.
- The board allowed the CEO to pursue the merger negotiations without close supervision by independent bankers or directors.
- The board concluded that the deal proposed by Kinder Morgan, although for a lower amount than the original deal proposed, was still more favourable than the one originally proposed by itself – the previously announced spinoff of El Paso's E&P business. The board's conclusion was based, in large part, on a valuation analysis by the conflicted banker, Goldman Sachs, on the value of the spinoff.
If a board entrusts a CEO as sole or key negotiator for a merger deal, that CEO's reasonably anticipated potential conflicts of interest must be carefully considered. Inquiries as to such conflicts should take place at the beginning of the deal negotiations. Management is virtually certain to have conflicts arising in any sale of control, resulting from its employment status or agreements governing compensation in a change of control. In the case at hand, beyond those employment-related conflicts, the board apparently never asked the CEO if he was interested in buying the spun-out E&P business, although it seems reasonably anticipated that management would have had some interest in taking over that business.
To address the conflicts of interest, the board could have interposed a Morgan Stanley banker or an independent director or committee to review the proposed deal and the full range of strategic and tactical decisions in the negotiations, such as the appropriate response to Kinder Morgan's puzzling reduction of its initial preemptive proposal. Goldman encouraged the El Paso board to avoid a hostile situation with Kinder Morgan; however, not only did Goldman have conflicts, but the CEO also had undisclosed incentives not to negotiate the highest price for El Paso, including his interest in leading a management buyout of the E&P business. An independent board or banker could have pushed harder to consider alternative strategies.
If a conflict of interest with a trusted bank adviser arises and a second bank is engaged, the board's attention and allegiance should shift to the second, unconflicted bank; the board should negotiate engagement terms that provide incentives for unconflicted advice. In this case, the board could have attempted to negotiate away Goldman's exclusivity, paid Morgan Stanley a fee if the spinoff transaction was chosen or could have agreed to pay a flat advisory fee credited against the transaction fee if the sale to Kinder Morgan was the alternative chosen.
If a bank has a conflict of interest causing it to favour a particular transaction, the board should view the bank's advice about alternatives to such a deal with scepticism. Thus, the advice that Goldman gave about the value of the spinout to El Paso stockholders had to be judged in light of what Goldman stood to gain if the Kinder Morgan deal was chosen.
It would be prudent to ask banks about individual banker conflicts. In the case at hand, the Goldman banker likely would have disclosed his personal interest in Kinder Morgan had he been asked.
Deal lock-ups should be negotiated with an eye to the most likely alternative transactions. Although the formulation of the definition of superior proposal was not 'off market' in requiring a proposal for a majority of the stock or assets of the company to be the subject of such proposal, the alternative actively being considered by the El Paso board was a spinoff of slightly less than 50% of the El Paso business. It made little sense to prohibit El Paso from talking to bidders about a deal for the E&P business, as that was the most likely alternative transaction to be considered by the El Paso board.
The El Paso decision, while not resulting in an injunction, provides useful lessons for boards of directors dealing with conflicts of interest.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.