Ignoring Chancery Court's Guidance on How to Act in Merger Transactions Could Jeopardize Deals
Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | May 04, 2011
The Delaware Court of Chancery, mindful of its role as a pre-eminent business court, works hard to communicate its expectations of officers and directors and their advisers. That facilitates predictability. Companies can be bought or sold with reduced risk that proposed transactions will be enjoined. The corollary is that when advisers and their boards do not follow the rules, they put their clients’ transactions at risk. Two recent cases illustrate that the Delaware Court of Chancery will not hesitate to enjoin a transaction where parties ignore clear guidance from prior opinions.
In its Feb. 14 decision in In re Del Monte Foods Co. Shareholders Litigation, the Court of Chancery enjoined a merger transaction from closing for 20 days and voided the deal protection terms that would have made a competing bid more expensive during that time period. It did so because of conflicts of interest by the seller’s investment adviser. The conflict arose because the seller’s investment adviser worked with the buyer to develop its merger proposal without telling the board, in apparent violation of a confidentiality agreement arising out of a previous failed effort to sell the company. It then sought a role in providing buy-side financing. All this while acting as financial adviser to the seller.
In enjoining the transaction the court relied on In re Toys "R" Us Inc. Shareholder Litigation, a 2005 case in which the court held that generally "it is advisable that investment banks representing sellers not create the appearance that they desire buy-side work, especially when it might be that they are more likely to be selected by some buyers for that lucrative role than by others."
Here the court found the investment adviser failed to disclose its conversations with prospective buyers or that it sought from the beginning to provide financing to the buyers. This prevented the board from taking steps to protect the integrity of the process. It also caused the seller to incur greater fees because once it was disclosed that the investment adviser sought to provide buy-side financing, the conflict required the board to obtain a new investment banker to opine on the fairness of the transaction. Thus, while "the blame for what took place appears at this preliminary stage to lie with Barclays, the buck stops with the Board," the court said in Del Monte.
The remedy the court fashioned was unique — voiding the deal protection terms while enjoining the closing to permit a 20-day go-shop — but reflects the traditional equity power of the court to fashion a remedy tailored to the breach. The court had no problem voiding the contractually bargained-for deal protection terms where the buyer knowingly participated in the board’s breach of fiduciary duty. In so doing, the Del Monte court emphasized, "After Vice Chancellor [Leo] Strine’s comments about buy-side participation in Toys 'R' Us, investment banks were on notice."
Three weeks later, in its March 4 decision in In re Atheros Communications Inc. Shareholders Litigation, the Court of Chancery enjoined another transaction where the board failed to disclose the nature and amount of the investment adviser’s fee. In Atheros the court found that stockholders voting on a proposed merger transaction would find it important to know that the investment adviser who rendered the fairness opinion upon which the board relied would receive 98 percent of its fixed fee only if a transaction closed. The court was not troubled by the contingent fee per se, but rather by the fact that more than 50 times the portion that was otherwise due would be received only if a transaction closed. As the court held, "the differential between compensation scenarios may fairly raise questions about the financial adviser’s objectivity and self-interest."
An additional factor justifying the court’s entry of injunctive relief was that the board did not disclose how soon in the process the seller’s CEO, who actively participated in negotiating the transaction price, knew that he would be staying on and receiving compensation from the buyer. The court thus required additional disclosure on this point, finding that information that the CEO knew he would receive an offer of employment from the buyer at the same time he was negotiating the offer price would be important to a reasonable stockholder in deciding how to vote.
Both of these cases demonstrate the vitality of the court’s observation in Del Monte, cited in Atheros, that "because of the central role played by investment banks in the evaluation, exploration, selection, and implementation of strategic alternatives, this court has required full disclosure of investment banker compensation and potential conflicts."
That guidance means that practitioners and advisers would be well-served to avoid conflicts, to counsel their clients to avoid them, and to disclose such conflicts promptly. Boards must also ensure that possible conflicts on the part of management who participate in the sale negotiations are properly managed by the board and fully disclosed. As these cases demonstrate, it is the board’s responsibility to manage the sale process and failure to follow clear guidance from the case law imperils prompt closing of potential transactions.
Lewis H. Lazarus (firstname.lastname@example.org) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm's clients.