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Dela-where? The ground rules for M&A transactions

honig-stephenWhat state has more corporations than people? Delaware, with approximately 950,000 people and well over a million registered corporations.

You would think that, given those demographics and the acceptance of Delaware courts as the premier authority in corporate law, practitioners would know how to obtain approval of an M&A “deal.” Unfortunately, that’s easier said than done.

Various publications periodically produce charts to provide a matrix for determining the proper method for getting M&A deals authorized by a constituent corporation. It is sometimes unclear which method should be applied for the discharge of director fiduciary duties. Each deal turns on its unique “facts and circumstances,” so little wonder we are confused.

This column will discuss current Delaware law on authorizing deals and the M&A chart in the July-August 2017 issue of Deal Lawyers at 8-12 (courtesy of Messrs. Gibson Dunn), and suggest a different approach to obtaining M&A deal authorization.

The business judgment rule — or BJR — is the general standard for measuring whether a director has discharged his or her fiduciary duty.

The BJR is a judicial construct that prevents courts from affixing liability on directors if they authorize a poor deal. There is a presumption that directors are protected by the BJR, and a plaintiff must prove the unavailability of the rule.

But there are limits to this protection. A director can fall outside the BJR if guilty of bad faith (such as by seeking unfair personal profit), or by failing to exercise the care of an ordinarily prudent person, or by wasting corporate assets, or by not believing the deal is in the corporation’s best interest (perhaps by unfairly favoring a control shareholder or an executive cadre).

Delaware courts have thus encountered many transactions that fall outside the BJR, suggesting director liability and voiding corporate approval of a deal. If you are outside of the BJR, a court must cure the process by determining the “entire fairness” of the deal — not a desired result.

How can a corporation escape an “entire fairness” court review, once having fallen into it? The chart is a compendium of methods by which a court’s entire fairness process can be avoided.

To understand the chart, it is necessary to understand its nomenclature.

An independent director is not on both sides of a transaction, does not expect personal profit, and is not so entangled with a control stockholder or management as to have corporate loyalty questioned.

Independence may be measured under various standards, including standards promulgated by securities exchanges and the SEC, but in a state court the inquiry is subject to subjective scrutiny.

Many legal observers have concluded that the intersection of business, personal and psychological factors makes that determination practically impossible. See my column in the February issue (“Being a board member certainly isn’t getting any easier”) discussing the Zynga case (Delaware Supreme Court) that examined subtle social and business factors and concluded that seemingly independent directors were in fact tainted.

“Entire fairness” is a high standard of court review of a deal to determine two things: fairness of price and fairness of process. Both prongs must be demonstrated, even if the price is found fair.

A “special committee” is a board committee made up entirely of independent directors.

The Chart

The chart identifies 11 different factual scenarios wherein a target corporation seeks to authorize a deal. Four qualify for BJR, where there is a majority of independent board members and no corporate insider is on the other side of the deal.

The seven remaining scenarios initially fall into the entire fairness requirement for one or more of the following reasons: a majority of directors or a controlling shareholder or a senior executive are getting a better deal; there is no independent director majority; there may have been an affirmative vote of a majority of either the independent board members or the independent minority shareholders, but without obtaining both approvals the facts of that particular deal are so troublesome that the deal must be reviewed by the courts.

To be specific (without identifying the specific factual differences of these seven), the cases themselves fall into no less than four categories, and entire fairness review is avoided (and the standard returns to BJR) if:

  1. There is either a special committee vote or a majority of disinterested shareholder vote to approve (two cases);
  2. A disinterested shareholder majority is obtained (one case);
  3. A special committee and disinterested shareholder vote both are obtained (one case);
  4. By reason of particular facts, both a special committee and a disinterested shareholder vote are obtained, and there is then a shift in the burden of proof back to the plaintiffs to prove impropriety (three cases).

We need to replace the current approach that we utilize when we attempt to gain corporate authorization for M&A transactions.

Analysis

You can see how the Delaware courts have struggled to find the middle ground between protecting directors and protecting shareholders. But the problem is, given so many possible factual scenarios, it is not always clear in which of these four categories your deal belongs.

Additionally, the development of the case law has fallen to litigators and courts. Without giving insult to my litigation colleagues, let me suggest that litigation-generated analysis is not always the best way for deal lawyers to plan a transaction, particularly since the dollars often are large, and the timing short.

And, with all these scenarios, litigation (particularly in the public M&A space) is frequent, creating delay, great legal costs, and costs of hiring experts and extra investment bankers. There has to be a clearer path.

Determining independence of directors also is vital in both the initial identification of cases requiring entire fairness analysis (absence of a majority of independent directors being a trigger) and the remediation of the issue short of an entire fairness court analysis (approval of a deal by a special committee, alone or together with shareholder action).

The answer

The obvious answer is to take the director test out of the equation. Let the directors vote, but since shareholders are the parties who are, or are not, harmed when the entire fairness test is failed, either because price is inadequate or (regardless of price) the process is unfair, why not just pass all deal approvals to a vote of the independent shareholders?

Several problems need to be considered in such a solution.

First, the shareholder meeting process takes time and money. But a challenged deal takes more, and many solutions set forth in the chart already require shareholder action anyway.

Second, shareholders need a great deal of granular information to have an informed vote. But under present practice, shareholders (who now must vote in some cases), and the directors themselves (who must always vote), must have that information.

Third, smaller private company transactions may be ill-positioned to absorb the costs. Shareholder injury in a small private company can be just as severe on a comparative basis as injury to a shareholder in a large public deal, but as a practical matter, it may be best to allow the directors in those smaller deals to vote for the transaction, regardless of independence, then obtain an independent shareholders’ vote, and then rely on back-end appraisal by any aggrieved shareholders.

Fourth, some have argued that even shareholder votes are irrelevant. An under-compensated shareholder always has a remedy of appraisal in mergers, so why not let directors, however they are constituted, do their business and vote the deal? And if a deal is unfair to shareholders, there is always appraisal. (Such an approach might lead to instituting mandatory appraisal in Delaware not only for mergers but also for asset sales; asset sale appraisal is not now available except by express charter inclusion.)

Fifth, if you take the directors out of the ultimate authorization process because they are presumed compromised, you avoid the disinterested director analysis entirely; the requisite approval in all cases is the independent shareholder vote. You can forget about wondering whether a majority of your directors are independent, avoiding ever falling into an entire fairness debate.

Requiring an independent shareholder vote in every deal may be a result that modern practice has avoided, in furtherance of speed and director-centric governance, but it does solve the entire debate as to whether you have to sort through your directors and give them a final category designation. (You are still left with sorting out the independence of shareholders, but that is a less subtle process.)

Conclusion

We need to replace the current approach that we utilize when we attempt to gain corporate authorization for M&A transactions. Current methods to obtain such authorization are needlessly complex and thus risky. The present system does not necessarily eliminate unfairness — and does not minimize litigation.

Utilitarian considerations may result in defining smaller deals with a less stringent approval regime, creating perhaps an option to simply rely on board approval with an appraisal. Larger deals will go to independent shareholder votes in all situations, with statutes prescribing disclosure materials (modified SEC proxy disclose standards?).

Directors will vote and recommend, regardless of bias; directors will disclose inter-relationships with interested parties (without analyzing whether they are “independent”). Then, independent stockholders will vote, and appraisal will backstop the process. Process will be clear and litigation discouraged.

This proposal has its defects, to be sure. But how does it compare to current practice?

Stephen M. Honig is a partner in the Boston office of Duane Morris. He acknowledges the assistance of law clerk Sukanya Hazarika, a member of the Indian bar.

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