The M&A Litmus Test: Part 2

Today is Day Two of your M&A Litmus Test, so we’ll continue by testing how well you know your …

…Fiduciary Duties.

Do your directors truly understand their role as fiduciaries? Corporate directors have duties of care and loyalty under state law, and these duties apply to the merger context. (The overarching duty of good faith—basically meaning integrity—need not be discussed here.) The duty of care requires that directors be informed and exercise appropriate diligence and good faith as they make business decisions and otherwise fulfill their general oversight responsibilities. The duty of loyalty requires that directors act in the best interests of the corporation rather than in their own interests.

When reviewing plans to buy another company, sell a company unit, or merge with another company, the board needs to exercise proper oversight of management (duty of care) especially in issues of strategy, pricing, and compliance with various legal obligations, such as disclosure obligations.

The board also needs to exercise independence (duty of loyalty). It can do this by maintaining its independence, and by appointing a special committee of the board composed entirely of independent directors to review a particular transaction.

One director who appreciates the importance of fiduciary duties in mergers is NACD Advisory Board member and HealthSouth director Charles M. Elson, who directs the John L. Weinberg Center for Corporate Governance at the University of Delaware. Recently we discussed the following question: What are the most important cases alleging violation of fiduciary duties in a merger? Two of his top picks were Revlon and Smith v. Van Gorkom.

Here are case summaries, according to Charles:

1. Revlon Inc. v. McAndrews & Forbes Holdings, Inc., Del. Supr., 506 A.2d 173 (1986). The court held that once the sale of a company has become inevitable, the directors of that company must seek to maximize the sale price for stockholders’ benefit.

In June, 1985, Pantry Pride approached Revlon to propose a friendly acquisition. Revlon declined the offer. In August, 1985, Revlon’s board recommended that shareholders reject the offer. Revlon then initiated certain defensive tactics. It sought other bidders. Pantry Pride raised its bid again. Revlon negotiated a deal with Forstmann Little & Co. that included a lock-up provision. Revlon also provided Forstmann with additional financial information that it did not provide to Pantry Pride. Eventually, an increased bid from Pantry Pride prompted an increased bid from Forstmann Little. The new bid was conditioned upon, among other things, the receipt by Forstmann Little of a lock-up option to purchase two Revlon divisions at a price that was substantially lower than the lowest estimate of value established by Revlon’s investment banker. It also included a “no shop” provision that prevented Revlon from considering bids from any third party. The board immediately accepted the Forstmann Little offer, even though Pantry Pride had increased its bid.

The questions before the court were: 1. whether the lock-up agreements were permitted under Delaware State law and 2. whether the Revlon board had acted prudently.

The Delaware Supreme Court held the following:

• Lock-ups and related agreements are permitted under Delaware law if their adoption is untainted by director interests or other breaches of fiduciary duties. The actions taken by the directors in this case did not meet that standard.
• Concern for various corporate constituencies is proper when addressing a takeover threat.
• Proper concern for multiple constituencies is limited by the requirement that there be some rationally related benefits accruing to the stockholders, and there were no such benefits in this case.
• When the sale of a company becomes inevitable, the duty of the board of directors changes from preservation of the corporate entity to maximization of the company’s value at a sale for the stockholders’ benefit. (This has come to be called the “Revlon doctrine.”)
• The board’s actions are not protected by the business judgment rule.

2. Smith v. Van Gorkom, Del. Supr., 488 A.2d 858 (1985). The business judgment rule fails to protect directors who make uninformed judgments.

Shareholders brought a class action against the board of directors of Trans-Union Corporation, alleging that the board was grossly negligent in its duty of care to the shareholders for recommending that the shareholders approve a merger agreement at $55 per share. Although the price per share was well above current market values, the shareholders alleged that it was inadequate. The Delaware Court of Chancery granted the directors summary judgment, and the shareholders appealed. The Delaware Supreme Court indicated that it would closely scrutinize the process by which the board’s decision was made.

Historically, courts generally did not interfere with the good faith business decisions of a corporate board; however, this case eroded that principle, and the court embarked on a road of increasing judicial scrutiny of business decisions. The court struck down the long-accepted practice of affording corporate directors the almost ironclad presumption that, in making business decisions, the directors act on an informed basis. Instead, it held that the determination of whether the business judgment of a board of directors is informed turns on whether the directors have essentially followed certain procedures to inform themselves prior to making business decisions. The court went on to say that there is no protection under the business judgment rule for directors who have made uninformed judgments.

Words to the wise from an experienced director!

Are you ready for Day Three?

Shout Out to Sources

• NACD Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies. Download a complimentary copy at www.NACDonline.org/LeadingtheWay.
• Report of the NACD Blue Ribbon Commission on the Role of the Board in Corporate Strategy
• Art of M&A Series, McGraw-Hill
• Report of the NACD Blue Ribbon Commission on Director Liability