The Delaware Court of Chancery's recent decision in In re: Mindbody Inc. Stockholders Litigation1 is important reading for lawyers whose practices include evaluating, addressing and — when necessary — litigating potential management conflicts in M&A transactions.
There, the court applied enhanced scrutiny under the Delaware Supreme Court's 1986 Revlon Inc. v. MacAndrews & Forbes2 decision and its progeny, and held that stockholder-plaintiffs stated potentially viable claims concerning an executive's alleged liquidity and interest in future employment, his manipulation of the sale process and his commission of a "fraud on the board."
In reaching that conclusion, the court rejected a ratification defense that was based on the Delaware Supreme Court's 2015 Corwin v. KKR Financial Holding LLC decision3 due to the corporation's alleged failure to disclose to the stockholders who approved the sale all material facts relating to the foregoing issues.
As a general matter, the court in Mindbody applied settled legal principles that govern in a sale of control of a Delaware corporation.
The fiduciary obligation to conduct a reasonable sale process untainted by self- interest is well-understood.
Delaware law also has long recognized that, in some circumstances, the liquidity needs of the target's substantial stockholders and the prospect of post-deal employment for its executives may create incentives that conflict with maximizing value.
It also is uncontroversial that withholding material facts from the board of directors and stockholders will prevent deferential review in the event of a stockholder challenge.
Mindbody's core lesson is reminding boards of directors of the importance of taking affirmative steps to uncover and manage actual and potential conflicts of interest in the sale process — in particular, those of the lead negotiators.
The Mindbody decision arose out of private equity firm Vista Equity Partners Management LLC's $1.9 billion take-private acquisition of Mindbody in February 2019.
The stockholder-plaintiffs allegations focused on (1) Mindbody's co-founder, CEO, and chairman, whose personal wealth was substantially concentrated in the company's stock, and who allegedly was motivated by personal liquidity needs and the prospect of future employment with the post-transaction company; and (2) Mindbody's chief executive officer, who allegedly was aligned with the CEO and similarly motivated by the prospect of future employment.
The plaintiffs alleged that the defendants tilted the sale process in Vista's favor.
Specifically, the founder/CEO was dissatisfied with having most of his personal net worth tied up in the company's stock, which he could only divest in small blocks — what he likened to "sucking through a very small straw."
He also had specific liquidity needs arising from renovating his home; supporting family members' businesses and large charitable commitments, and was attracted to Vista's business model of acquiring companies and providing attractive post-acquisition compensation, incentives and upside for management teams.
As alleged, the CEO and CFO kept Vista's initial expression of interest from the full board, and manipulated earnings guidance downward to depress the company's stock price and make it a more attractive target for Vista.
In a truncated due diligence and bidding process, the CEO rebuffed potential acquirers for whom he did not wish to work while providing Vista with more information than other potential acquirers.
And the CEO withheld material information concerning his potential conflicts and deal-related conduct from the board, which in turn failed to oversee the sale process adequately.
Finally, the transaction's proxy statement allegedly omitted material information relating to the CEO's conflicts and recent earnings results showing that Mindbody had outperformed its previous and allegedly artificially deflated guidance.
The defendants moved to dismiss.
The Court of Chancery granted in part and denied in part the defendants' motion.
Under Revlon, Delaware law requires fiduciaries managing a corporation in a sale of control to act reasonably to maximize the consideration to stockholders.
As the court observed, "[t]he sins of just one fiduciary can support a viable Revlon claim," where "that one conflicted fiduciary failed to provide material information to the board or that the board failed to sufficiently oversee the conflicted fiduciary."
Here, the plaintiffs stated a paradigmatic Revlon claim, i.e., involving "a conflicted fiduciary who is insufficiently checked by the board and who tilts the sale process toward his own personal interests in ways inconsistent with maximizing stockholder value."
The allegations concerning the CEO's self-expressed liquidity needs and desire for future employment with Vista adequately pled a conflict; and the allegations concerning the lowered revenue guidance and the manipulation of the sale process pled a reasonably conceivable breach of fiduciary duties.
Further, the plaintiffs failure to allege that a majority of the board of directors was interested in, or lacked independence in, the sale process was not fatal to their case because the complaint adequately pled a failure to disclose all material information to the board — i.e., the "fraud-on-the-board" theory discussed in Mills Acquisition Co. v. MacMillan Inc.4 and its progeny.
Fraud on the board neutralizes the otherwise inoculating approval of a board majority comprised of disinterested and independent directors.
The court also rejected the defendants' argument that the stockholder vote approving the transaction satisfied Corwin v. KKR Financial Holdings LLC5 and required dismissal.
As the court observed, where, as here, the allegations support the paradigmatic Revlon claim, "it will be difficult to show on a motion to dismiss that the stockholder vote was fully informed."
The court observed numerous allegedly material disclosure deficiencies, including many of the same facts underlying the breach of fiduciary duty claim against the CEO, which supported that the Mindbody stockholder vote was uninformed.
Finally, the court went on to hold that the complaint stated a breach of fiduciary duty claim against the CFO.
The allegations supported that he was recklessly indifferent to the steps the CEO took to tilt the sale process in Vista's favor, stating a claim for at least a breach of the duty of care.
That sufficed to avoid dismissal, because his conduct as an officer was not subject to exculpation pursuant to Title 8 of the Delaware Code, Section 102(b)(7).
Mindbody offers several important lessons.
As an initial matter, the court's opinion serves as a reminder of the risks presented by relatively informal or extemporaneous communications during the deal process.
The detailed factual allegations supporting the CEO's potential conflicts and purported misdeeds were aided by the plaintiffs presuit books and records inspection under Title 8 of the Delaware Code, Section 220 — one that apparently encompassed emails and text messages.
In the years since Corwin, stockholders have employed statutory inspection rights to conduct presuit investigations of M&A transactions when they suspect a potential disclosure violation that would undermine a ratifying vote.
A growing body of Delaware cases support that informal communications may be subject to inspection when they are essential to a stockholder's purpose of investigating suspected wrongdoing or mismanagement.
Considering the relatively low standard of proof to support a Section 220 inspection, as well as other means for such communications to come to light, directors and officers should be aware that communications they may consider private or relatively unimportant at the time — including emails, texts or messages sent through social media or other applications — may be aired in a public forum.
If and when that happens, at least at the pleadings stage, those communications may be presented in a manner that best serves the plaintiff's theory of liability and will be construed in a light most favorable to the plaintiff, perhaps omitting context the communicating parties feel is important.
In the early stages of litigation, directors and officers confronted with communications they believe are cherry-picked or misconstrued may lack the practical ability to respond and provide their side of the story.
Mindbody also illustrates the importance of identifying, monitoring, addressing and appropriately disclosing material conflicts of interest in the M&A process.
That includes, in particular, the actual and potential conflicts of any senior executives with a significant role in efforts to identify and solicit potential acquirers, to provide them with due diligence, and to negotiate over price or other important deal terms.
A fiduciary or adviser involved in the process with interests that may be misaligned with maximizing value for all stockholders may act, or be perceived to act, to shape the decision-making or information flow in a manner that creates business and litigation risk.
As Mindbody illustrates, an arguably conflicted executive leading a deal process is a conspicuous target, particularly where the known facts are amenable to an interpretation that he or she was not subject to the appropriately careful supervision of a disinterested, independent and well-functioning board of directors.
As the late great Muhammad Ali once said — in the corollary to his famous "float like a butterfly, sting like a bee" line — one's "hands can't hit what his eyes can't see."
That fact carries over to the boardroom.
Where materially diverse interests emerge before or during the deal process, but remain concealed, the board and counsel cannot evaluate and cabin the resulting risks in real time in a manner consistent with Delaware law.
It follows that a board's handling of potential conflicts should involve affirmative, direct, and continuing efforts to identify and address risks of this kind.
Mindbody reinforces the need to include in that exercise two important areas of inquiry.
The first is any significant, imminent liquidity needs of key persons.
While settled law holds that a fiduciary's ownership of stock tends to align his or her interests with those of the corporation's stockholders generally, personal liquidity needs in some circumstances may alter this incentive structure and the time-horizon for value maximization.
Accordingly, a board's deliberations regarding whether to initiate a sale process and how to oversee one should consider the potential idiosyncratic financial situations of key persons in a position to influence the decision-making or sale processes.
Minimally, the board should perceive the relevant individual's public statements on the matter — plaintiffs counsel usually do.
A second area for inquiry is management's post-deal employment objectives.
The board should oversee any employment discussions between members of management and potential bidders, and insist upon timely disclosure to the board of any such communications.
Relatedly, the board should, at an early stage, consider inquiring into the company's executives post- deal employment objectives, and how best to shape and monitor the process of communicating with bidders in light of the same.
The issue of management's potential self-interest may come to the forefront in the board's consideration of whether a process should include potential strategic acquirers, who may be less inclined to retain management post-transaction.
Relatedly, as a general matter, the board should be apprised promptly of any expressions of interest or similar contacts between high-ranking executives and potential acquirers.
Failing to do so can set the stage for claims of a defective process.
When such contacts occur, the directors would be well-served to seek to understand the full extent of those communications.
Once a board identifies potential areas of conflict, directors must respond and appropriately manage them.
This may involve sidelining the affected individuals or reducing their roles in the process.
In general, the board should take steps to ensure that disinterested and independent directors and their advisers lead the deal process.
That is the ideal means to facilitate all material information making its way to the boardroom and to secure a level playing field among potential bidders in the interest of value maximization.
As Mindbody suggests, the diligence process both at the outset and during any go-shop period are vulnerable to manipulation and require real-time, impartial oversight.
Finally, when a board identifies potential conflicts that may be important to a stockholder's decision whether to approve a transaction, the directors should work with counsel to consider the appropriate amount of disclosure in connection with the stockholder vote.
Appreciating these potentially consequential issues will help a company ensure that it fulfills its disclosure obligations.
A board's best efforts may not always preclude any possible perception of conflicts of interest or arguable process flaws.
But at bottom, full disclosure of all such matters remains the path under Corwin to deferential business judgment review and the attendant reduction of personal liability risk for directors and officers.
K. Tyler O'Connell Albert J. Carroll
Reprinted with permission from Portfolio Media Inc.