With liquidity problems looming and prospects for a successful exit becoming more distant, today's capital market is driving many VCs and private equity groups to triage their investments and look for exits where possible. As typical for most venture capital investments (and as prescribed by the NVCA model legal documents), investors often get one or more board seats in their portfolio companies and have significant veto power over key corporate decisions, which in effect convert their minority positions into ones of potential control. The power granted by these rights pose potential conflicts of interest. These issues are magnified when a company is considering a sale, especially in a down market economy, when opinions over this key decision may vary between founders, angels and VCs.
Two recent decisions by the Delaware Supreme Court, each reversing the Chancery Court's earlier rulings, provide new guidance in this area.
Gantler v. Stephens In January 2009, the Delaware Supreme Court held in
Gantler that directors and officers of an Ohio bank could be found to have breached their fiduciary duty by rejecting an opportunity to sell their bank and instead pursuing a recapitalization that favored the insiders. The defendants were also accused of sabotaging the due diligence process and not taking the sale process seriously.
In short, the historical position under Delaware corporate law has been that certain conflicts of interest of insiders (such as trying to keep one's employment or directorship) are inherent and unavoidable. If properly disclosed, these conflicts would not result in a higher level of scrutiny from courts over board decisions.
Gantler holds that this is not always true, and that specific facts can alter that position. Specifically, where directors and/or officers are -- or with 20/20 hindsight, may be argued to be -- motivated to prefer one particular transaction over another, even if the motivation is reasonable and disclosed to shareholders, extreme care should be taken to ensure that the board evaluation and deliberation process is balanced and well-documented.
Gantler clarifies several issues of Delaware corporate law:
§ Higher Scrutiny for Transactions with Potential Conflict of Interest. The Court agreed with the defendants that the Board's duty in this case should be analyzed under the more favorable “business judgment rule”, as opposed to the "enhanced scrutiny" standard under
Unocal. However, the business judgment presumption
could be rebutted in this case because reasonable inferences of self interest could be drawn from management's lack of cooperation with the sale process. The Court highlighted specific conflicts arising from a business sale, such as loss of employment for the Chairman/CEO, and the loss of the bank as a key client for businesses operated by two different directors. It is also interesting to note that the Court relied on the disclosure in the proxy statement of the potential for conflict of interest as an admission that the conflict did in fact exist.
There can be little question that the extreme facts of this case heavily influenced the Court's decision to rebut the presumption of good faith by the board. The outcome may have been different if the some of the"sabotaging" activity was not present and if the board deliberations regarding the sale proposals were more extensive. The Court specifically noted that after only one bidder remained and the bankers opined that the bidder may continue to improve their offer, the board did not discuss the offer at one meeting and rejected in another, "without discussion or deliberation."
Gantler should not, however, be read to require a board to reach any particular decision (e.g. sell, recapitalize, etc.), but only that the process to reach that decision is fair and informed. Therefore, to the extent that certain opportunities can later be reasonably argued to have been more preferable for certain (minority) shareholders, boards should be advised to more carefully evaluate those opportunities and to document why they may not have been in the best interests of
all shareholders.
Where a potential conflict does exist, boards should be advised to consider the appointment of an independent committee for the M&A process, where such committee would have the authority to engage its own advisors and independent legal counsel. Another approach may be to engage multiple investment banking advisors to provide a board with a comparative analysis of the opportunities. Finally, extreme care should be take to distribute all studies, reports and materials in advance of board meetings, to have substantive discussions on those issues at the meetings and properly memorialize in the minutes to evidence that the board fulfilled its duty of care (which it would seem was not met in
Gantler).
§ Fiduciary Duty of Officers equal to that of Directors. As an issue of first impression, the Court held that officers of a Delaware corporation have the same fiduciary duties as directors. While this position has been implied, the Supreme Court has now explicitly held that officers owe fiduciary duties of care and loyalty that are the same as those of directors of Delaware corporations.
§ Shareholder Ratification Limited. The Court also disagreed with the Chancery Court's finding that the shareholder approval of the privatization plan, as submitted by the Bank's board and described in the proxy, "ratified" the prior actions of the board, absolving them of liability. To clarify this area of the law, the Court imposed a number of specific limitations on this doctrine.
First, shareholder ratification is effective only where a "fully informed shareholder vote approves director action that
does not legally require shareholder approval in order to become more legally effective." Therefore, where a shareholder vote is otherwise required “ such as for the approval of a charter amendment or a merger “ the shareholder vote does not carry any ratifying effect of the preceding board action.
Second, the only director action that can be ratified is that which shareholders are specifically asked to approve. For example, the ultimate approval of a merger by shareholders does not mean that shareholders have also ratified all related director actions, such as defensive measures that may have been taken in the context of that transaction.
Third, the effect of shareholder ratification
does not extinguish all claims in respect of the ratified director action, but rather subjects the challenged action to business judgment rule review. Therefore, companies should not assume that a valid shareholder vote would sanitize the prior actions of a board in connection with any particular corporate decision or transaction.
Lyondell Chemical Corp. v. Ryan In March 2009, in
Lyondell Chemical Corp., the Supreme Court ruled this time in favor of the defendant directors, finding that a market check is not absolutely required by a board to meet its so-called "
Revlon duties" before accepting a particular offer to sell the company.
Somewhat conversely to
Gantler, this decision should provide additional comfort to boards that may not have the time or luxury to conduct a market check or other analysis before accepting a deal that they deem, based on their general knowledge, to be in the best interests of the stockholders.
In its reversal, the Supreme Court held that the Chancery Court misinterpreted the scope of the
Revlon duties in three ways.
§ Revlon duties do not commence when the company is put "in play" - such as from the filing of a Schedule 13D by a potential hostile acquirer - but rather when the board begins negotiations of the company's sale. The plaintiffs had claimed that the directors' failure to begin to actively market the company once it was "in play" was a violation of their
Revlon duty, which the Supreme Court rejected.
§ Revlon does not require directors to follow any specific blueprint to obtain the best available price, such as by either conducting an auction or conducting a market check. The Court emphasized that there are no legally prescribed steps that directors must follow, and "no court can tell directors exactly how to accomplish that goal."
§ Similarly, the Court emphasized that directors' decisions must be "reasonable, not perfect." In the transactional context, an "extreme set of facts is required to sustain a disloyalty claim." Here, the Board met on several occasions, was
generally aware of the company value and the chemical company market, followed the advice of their financial and legal advisors and attempted to negotiate a higher offer, even though the evidence indicated that the offer was a "blowout" price. The Court noted that even if the Board did nothing to prepare for the offer, and did not consider conducting a market check before agreeing to the merger, the totality of the facts did not show that the directors breached their duty of loyalty by failing to act in good faith.
Dimitry Herman is a partner in the Boston office of Hinkley, Allen & Snyder. His blog,
Furthur Assurances, addresses timely issues facing investors and entrepreneurs.
