Uncounted reams have been devoted to descriptions of duties of
directors of US target companies in the context of M&A
transactions. Interest in this topic endures for two main reasons.
First, the issues are complex: the standards applicable to target
boards have proliferated, kudzu-like, so that any of five different
legal standards might be used to test a decision of a Delaware
target's board, depending on the circumstances. Second, the stakes
are high: the decision to sell a company is one a target board
typically gets to make only once, and target shareholders, who are
deeply interested in the result, have not been shy about
complaining if they feel the decision was mishandled.
What about the decisions of boards of acquiring companies? Are
the issues less complex for boards thinking about buying, rather
than selling, a company? Do shareholders of acquiring companies
care less about the outcome?
If it ever was safe to answer yes to these questions, today's
increasing scrutiny of board decision-making processes makes it
risky for directors to adopt a casual attitude towards buying other
companies.
The business judgment rule
US courts have traditionally deferred to the business judgment
of directors if they act in good faith, with loyalty to the
corporation, and on an informed basis. The presumption that
director actions satisfy these requirements is known as the
business judgment rule. As the Delaware Supreme Court put it in
Brehm v Eisner, a 2000 case involving Disney's large
severance payment to Michael Ovitz, "Courts do not measure, weigh
or quantify directors' judgments. We do not even decide if they are
reasonable in this context. Due care in the decision-making context
is process due care only. Irrationality is the outer limit
of the business judgment rule."
In most cases, the business judgment rule will apply to a
board's decision to acquire another company. Courts will not
second-guess the informed decision of a disinterested board to
approve an acquisition - even if that acquisition turns out badly.
The heightened levels of scrutiny courts have applied to target
boards - the Revlon test of whether the board has sought the
highest price reasonably available in a change of control context;
the Unocal test as to whether defensive actions are
reasonable in relation to a reasonably perceived threat; the
Blasius test as to whether actions that interfere with
shareholder voting are undertaken with a compelling justification;
and the entire fairness test applicable to going private
transactions with controlling shareholders - have not typically
been applied to boards of acquiring companies. That is largely
because courts have perceived there to be a conflict of interests
on the part of target boards, which may come from their desire to
remain in office, or because of their ties to target management who
may be displaced in a transaction, but which is not usually present
when the director is on the buy side.
Moreover, Delaware, and most other states, have adopted laws
permitting corporate charters to limit directors' personal
liability for breach of the duty of care - with exceptions.
Delaware, for instance, does not allow a corporation to limit a
director's liability for "acts or omissions not in good faith or
which involve intentional misconduct or a knowing violation of
law."
Does the existence of the business judgment rule, coupled with
exculpatory charter provisions, mean that non-conflicted directors
of acquiring companies can exhale?
Not necessarily. On January 12 2005 - the sixth anniversary of
McKesson Corporation's merger with HBO & Company - McKesson
agreed to pay $960 million to settle securities class action
litigation arising from HBOC's restatement of earnings as a result
of improperly recorded revenues. In a single day, McKesson lost
over $9 billion in market value when it first disclosed, less than
four months after the closing, that HBOC had overstated earnings.
While McKesson has settled with the class action plaintiffs, the
settlement does not cover pending claims that McKesson's directors
breached their duties by not discovering HBOC's fraud.
McKesson's directors have the benefit of an exculpatory charter
provision, but in Ash v McCall, a 2000 Delaware chancery
court decision that dismissed without prejudice claims that the
McKesson board breached its fiduciary duties by approving the HBOC
deal, the court made clear that litigation against the McKesson
directors could proceed if plaintiffs are able to allege particular
facts demonstrating bad faith on the part of directors - including
facts indicating that the directors "had actual knowledge of
accounting irregularities, or knowledge of facts indicating
potential accounting irregularities, and took no action..."
Another example of an acquisition with ruinous consequences:
just four months after the merger of CUC International and HFS to
form Cendant Corporation, Cendant announced that management had
discovered accounting irregularities at CUC - causing Cendant's
market capitalization to drop by $14 billion in a single day.
Cendant ended up settling the ensuing litigation for over $2.8
billion.
While these examples have not to date resulted in personal
liability for directors, the recent Enron and WorldCom settlements,
in which directors agreed to pay millions of dollars toward
settlement funds (although the WorldCom settlement later failed to
win court approval), are sobering reminders that directors may face
personal risk for serious failures of oversight.
The duty of good faith
Recent Delaware case law has made clear that directors can be
held personally liable, even if their companies' charters exculpate
them from liability for duty of care violations, if their conduct
is found to be sufficiently egregious.
For example, in the most recent chancery court decision arising
from Disney's severance payments to Michael Ovitz, chancellor
Chandler said the facts alleged did not implicate merely negligence
or gross negligence, but instead suggested that the directors had
not "exercised any business judgment or made any good
faith attempt to fulfill the fiduciary duties they owed to Disney
and its shareholders." According to the court, the alleged facts
suggest the defendant directors "consciously and intentionally
disregarded their responsibilities" - meaning, if true, that "the
directors' actions are either not in good faith or involve
intentional misconduct."
In the Abbot Laboratories case, the Seventh Circuit,
applying Illinois law similar to Delaware's, held to be legally
enough allegations that Abbott Laboratories directors knew of
significant problems (repeated notices of FDA rule violations) but
took no action. The allegations, if proved, showed a "systematic
failure of the board to exercise oversight." To the court, six
years' noncompliance resulting in the FDA's largest civil fine
"indicate that the directors' decision to not act was not made in
good faith," and the claims were not precluded by a charter
liability limitation.
In the Emerging Communications case, which involved a
going private transaction at a price the court found to be only
about 27% of the company's actual value, an outside director was
found jointly and severally liable for money damages for voting to
approve the transaction "even though he knew, or at the very least
had strong reasons to believe, that the...merger price was
unfair."
Why was the director not protected by the company's exculpatory
charter provision? The court held the director had breached his
duty of loyalty and/or good faith, making him ineligible for
exculpation. Why was he not protected in relying on the special
committee that approved the transaction, or on the investment
banker that opined that the price was fair? The court does not
address this question squarely, but the answer is the same:
directors are fully protected in relying on committees, management
and carefully chosen experts as to matters within their expert
competence - but only if that reliance is in good faith.
While these cases do not specifically address duties of buy-side
directors, it is not hard to see how the legal theories used in
these cases, which lead to personal liability for directors, can
also apply in the acquisition context. Directors necessarily
delegate much of the work in an acquisition to company management
and to outside experts. In most cases they will be fully protected
in doing so. But if directors fail to inform themselves of a large
acquisition that leads to post-closing problems, the business
judgment rule will not protect them. Similarly, if directors
actually know there is something wrong with the target, or that the
company is overpaying, they cannot close their eyes to the problem
and rely blindly on the assurances of management or outside
advisers. It is unfortunate, but nevertheless true, that directors'
actions tend to be judged with the benefit of hindsight. This is
especially troubling when courts apply inherently imprecise
standards, such as inquiring as to whether directors have acted in
good faith, at a time when the transaction has proven to have been
a mistake.
Am I buying or selling?
Directors of acquiring companies must be mindful that in
stock-for-stock transactions, they are selling part of their own
company as well as buying another company. Sometimes in these
circumstances, particularly when acquiring company shareholder
approval will be required for the transaction, acquiring company
boards are asked to bless voting lock-ups, no-shop provisions and
other deal protection devices. The decision to approve measures
intended to protect the deal may be subject to greater judicial
scrutiny than the decision to enter into the deal itself. Directors
should understand how the deal protection provisions work, and
should consider whether they are reasonable and whether they will
have the effect of limiting their ability to exercise their
fiduciary duties in the future. Directors should also be alert to
factors that have led courts to perceive that directors have a
conflict of interests - for example, in a large acquisition, if
some of the buyer's directors will no longer serve as directors of
the combined company.
Staying out of trouble
Here are some things directors and their advisers should keep in
mind to help reduce the chance that a court will second-guess a
board's decision to acquire another company:
Make decisions. The business judgment rule protects
decisions of the board, not failures to make decisions. That means
that significant acquisitions should be reviewed by the board. If
the board has a policy of delegating to management responsibility
for acquisitions below a specified threshold, it should make sure
it has a process in place to ensure that those acquisitions do not
involve risks extending beyond that threshold.
Stay informed. Directors should understand the
transaction, including potential risks that arise through the due
diligence process. Failing to tell the directors about potential
risks does not help them show that they exercised informed business
judgment - which can include taking risks. Directors should also
understand the workings of any deal protection devices applicable
to the acquiring company.
Have a good process. For large acquisitions, it is
helpful to have multiple board meetings - so that directors have
ample opportunity to ask questions, and so that their concerns can
be addressed in the deal terms.
Make effective use of experts. Under the law of Delaware
and most other states, directors are fully protected in relying in
good faith on reports and opinions of management, committees and
carefully chosen experts as to matters within their expertise.
Author
biography
William D
Regner
Debevoise &
Plimpton LLP
William D Regner is a partner in the New York office of
Debevoise & Plimpton LLP. His practice focuses primarily on
mergers and acquisitions, including public company and cross-border
transactions, as well as investment management, corporate and
securities law matters.
William Regner has played a key role in numerous M&A matters
for the firm, including Verizon Communications' pending acquisition
of MCI. He regularly represents prominent investment banking firms
in their role as financial adviser in major transactions. He worked
on the Chrysler-DaimlerBenz merger, the Phelps Dodge double
unsolicited exchange offer, and handles many of the firm's M&A
assignments in the asset management sector.
William Regner is the co-author of Takeovers: A Strategic
Guide to Mergers & Acquisitions (Aspen Law & Business
2004) and has written numerous articles on mergers and acquisitions
and corporate law matters.
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