Extracted from Law360
As the global economy began to recover in 2021 from the prior year's coronavirus-related slowdown, deal-making activity soared.
Many factors drove the surge, including low interest rates, the use of U.S. special-purpose acquisition companies and increased private equity activity.
The flurry of merger and acquisition activity is projected to continue well into 2022 across the market, from private to public companies and small to multibillion-dollar transactions.
This rise is expected to be most pronounced in the technology sector that has thrived during 2021 and that remains the focus of private equity investment.[1]
With this projected increase in deal flow in the coming year, directors of a wide variety of companies may well face questions about whether to engage in a strategic transaction.
Directors confronted with such an opportunity should closely consider what is required to fulfill their fiduciary duties in the context of such a transaction.
A review of Delaware case law, including the recent illustrative case of Flannery v. Genomic Health Inc.,[2] provides helpful guidance to directors approaching decisions about whether to engage in a transaction in the coming year.
Back to Basics: Fiduciary Duties of Directors
When assessing a potential strategic transaction, directors of Delaware corporations should bear in mind their two fundamental duties to shareholders: the duty of care and the duty of loyalty.
The duty of care requires directors to act on a reasonably informed basis after due consideration of relevant information and appropriate deliberation. In doing so, directors may frequently rely on the advice of legal and financial advisers and management.
The duty of loyalty requires directors to act independently — in good faith and in the best interests of the shareholders and the corporation, rather than in bad faith or their own interests.
How Courts Analyze: Standards of Review
Directors considering a strategic transaction in 2022 should also consider the three standards of review that courts apply under Delaware law when assessing a board's decision to engage in such a transaction.
Business Judgment Rule
Director decisions by default fall within the business judgment rule, which accords substantial deference to board decisions.[3]
This means that in litigation, for most board decisions, courts will presume that the board acted on an informed basis, in good faith and with the honest belief that the action taken was in the best interests of the corporation and its stockholders.[4]
A board's actions before a decision to pursue a sale of control of a company typically fall under the business judgment rule.
Board decisions to provide diligence materials to a third party, to engage in preliminary discussions with a potential acquirer or to engage in a broader process to consider strategic alternatives are all subject to the business judgment rule.
Enhanced Scrutiny Under Revlon
If the board decides to undertake a sale of control, including through a potential merger or acquisition, then the board may be required to show that it acted reasonably to obtain the best transaction reasonably available to maximize stockholder value under the circumstances.
This is commonly referred to as the board's Revlon duty[5] — from the Delaware Supreme Court's 1986 decision in Revlon Inc. v. Macandrews & Forbes Holdings Inc. — and courts apply enhanced scrutiny when determining whether the board upheld that duty.[6]
When considering a transaction that may trigger a board's Revlon duty, directors should bear in mind that the "duty to seek the best available price applies only when a company embarks on a transaction — on its own initiative or in response to an unsolicited offer — that will result in a change of control,"[7] as articulated by the Delaware Supreme Court's 2009 decision in Lyondell Chemical Co. v. Ryan. This includes:
- When a company begins an active bidding process with the goal of selling itself or reorganizing the business with a "clear breakup of the company,"[8] as held by the Delaware Supreme Court in its 1994 Paramount Communications Inc. v. QVC Network Inc. decision;
- When a company "abandons its long-term strategy and seeks an alternative transaction involving the breakup of the company" in response to an interested party's advance, as held by Delaware's highest court in its 1990 Paramount Communications Inc. v. Time Inc. ruling;[9] and
- When a company enters into a transaction resulting in a change of control.
Further, directors should remember that Revlon duties require a board to take reasonable steps to obtain the best transaction reasonably available under the circumstances to maximize stockholder value, including price, terms and execution risk.
That does not necessarily mean that the board is required to accept the highest bid price, as the offer with the highest price may have downsides that make it less valuable, such as greater risk of not closing or a less financially sound counterparty.
Directors should also be aware that courts review multiple factors when assessing a transaction under Revlon, including the method of sale and types of buyers considered by the board.
When assessing a strategic transaction and how to maximize shareholder value, directors should consider the risks and benefits of various methods of sale, which commonly include:
Single-Bidder Process Followed by Post-Signing Market Check
While Revlon does not require any specific process generally, the most demonstrable method for maximizing stockholder value is often to allow the market to function through a public or private market check in a sale process.[10]
Public Disclosure of Intention to Evaluate Strategic Alternatives
A board may also consider publicly disclosing its intention to evaluate strategic alternatives to place potential bidders on notice, and then wait a reasonable period of time before engaging the transaction to allow potential bidders to place bids.[11]
Broad Direct Solicitation of Potential Buyers
A board may also directly approach multiple financial and strategic buyers to ensure that they have maximized shareholder value.[12]
Directors also face the decision of what type of buyer to seek. While directors are not required to seek both financial buyers and strategic buyers for the company to evidence that they have considered the interests of the company's shareholders, doing so may later assist the board in combating allegations that a transaction was tainted by conflicts of interest.[13]
Entire Fairness
Finally, directors should be mindful that courts apply an even higher standard of review — entire fairness — in certain situations where
- In the words of the Genomic Health decision, "the propriety of a board decision is in doubt" because a majority of the directors who approved the decision were conflicted, acted in bad faith or were grossly negligent; or
- The "transaction involved a controlling stockholder."[14]
Don't Forget: Conflicts of Interest and Personal Motivations
Particularly in a fast-paced deal environment like that predicted for 2022, directors should be mindful of conflicts of interests in the context of a potential transaction.
These issues are of paramount concern to courts in evaluating whether a director breached his or her fiduciary duties when determining whether to accept an offer to purchase the corporation.
Courts routinely hold, as the Chancery Court laid out in March in In re: Columbia Pipeline Group Inc., quoting precedent, that
"[A] board may not favor one bidder over another for selfish or inappropriate reasons." ... "[A]ny favoritism [directors] display toward particular bidders must be justified solely by reference to the objective of maximizing the price the stockholders receive for their shares." A board "may tilt the playing field if, but only if, it is in the shareholders' interest to do so."[15]
And, as articulated by the Chancery Court last March in In re: Tesla Motors Inc. Stockholder Litigation, quoting the Delaware Supreme Court's 1993 decision in Cede & Co. v. Technicolor Inc.,
"Classic examples of director self-interest in a business transaction involve either a director appearing on both sides of a transaction or a director receiving a personal benefit from a transaction not received by the shareholders generally." Directors may also be found to lack independence when they are beholden to an interested party.[16]
A Recent Application: Flannery v. Genomic Health
Flannery v. Genomic Health, decided in the Delaware Chancery Court by Vice Chancellor Joseph R. Slights III in August, illustrates how courts apply these concepts in practice.
In Genomic Health, a stockholder plaintiff challenged the process leading to Genomic's July 2019 merger with Exact Sciences Corp., alleging that, among other things, Genomic's board breached its fiduciary duties by failing to obtain a fair price for Genomic's stockholders.
The plaintiff argued that the entire-fairness standard should apply because the merger was allegedly the product of the undue influence of a controlling stockholder engaged in a conflicted transaction or, alternatively, that enhanced scrutiny under Revlon should apply because the merger was, or should have been, the result of an active bidding process that led to a change of control transaction and that, accordingly, the board failed to maximize the value of the transaction.
The court dismissed the complaint and held that the plaintiff failed to plead a breach of fiduciary duty by Genomic's board.
The court held that the entire-fairness standard did not apply because the alleged controlling shareholder did not own more than 50% of the voting power of Genomics, did not exercise general control over the company, did not exercise undue influence over any director and did not act under a conflict of interest that rendered the merger conflicted.
The court held that enhanced scrutiny under Revlon also did not apply because the merger was the result of a direct approach by a single party that did not result in a change of control.
The court concluded that, because the plaintiff failed to rebut the presumption of the business judgment rule and did not purport to plead a claim for waste, her claims against the directors should be dismissed.
Looking Ahead
It remains to be seen whether the coming year will usher in the anticipated record-breaking round of deal-making activity.
Directors preparing for the potentially hot market and active deal landscape should bear in mind some central lessons from prior years:
- Thoughtful consideration: While directors may encounter a rush to close a transaction, it is important for boards to take the time necessary to closely consider the benefits and drawbacks of any potential transaction.
- Documentation: It is critical that directors ensure that there is a contemporaneous record, including carefully drafted board minutes, of meetings considering a potential transaction. These materials often may be essential to a board's defense if a transaction takes place and the company has to describe its material decisions and negotiating process to its stockholders or to a court.
- Conflict disclosure: Directors should disclose conflicts of interest to the board and, as needed, to the shareholders, particularly given plaintiffs' frequent focus on alleged conflicts in their complaints.
- Special committee: If a majority of the board is conflicted, the board should consider setting up a special committee of nonconflicted directors or seeking the input of independent, noninterested directors on the transaction.
[1] Jessica Yount, Dealmakers Are Bullish on Tech M&A in 2022, but Regulation Threats Loom, The Recorder, Law.Com (Sep. 30, 2021), https://www.law.com/therecorder/2021/09/30/dealmakers-are-bullish-on-tech-ma-in-2022-but-regulation-threats-loom-403-67744/.
[2] Flannery v. Genomic Health, Inc., No. 2020-0492-JRS, 2021 Del. Ch. LEXIS 175 (Del. Ch. Aug. 16, 2021).
[3] McMullin v. Beran, 765 A.2d 910, 916 (Del. 2000).
[4] Id.
[5] McMullin, 765 A.2d at 918 (citing Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986)).
[6] A transaction otherwise subject to enhanced scrutiny will still ultimately be assessed under the business judgment rule if that transaction: (1) has been approved by a majority of fully informed and uncoerced stockholders; or (2) has a supermajority of the consideration consisting of stock in a company whose shares are held in a large, fluid market (i.e., a stock-for-stock deal). See Larkin v. Shah, No. 10918-VCS, 2016 Del. Ch. LEXIS 134, at *39, *42 (Del. Ch. Aug. 25, 2016).
[7] Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 243 (Del. 2009).
[8] Paramount Commc'ns, Inc. v. QVC Network, Inc., 637 A.2d 34, 47 (Del. 1994), quoting Paramount Communications, Inc. v. Time, Inc.
[9] Paramount Commc'ns, Inc. v. Time, Inc., 571 A.2d 1140, 1150 (Del. 1989).
[10] C&J Energy Servs. v. City of Miami Gen. Emps.' & Sanitation Emps.' Ret. Tr., 107 A.3d 1049, 1067-68 (Del. 2014).
[11] See, e.g., In re Appraisal of PetSmart, Inc., No. 10782-VCS, 2017 Del. Ch. LEXIS 89 (Del. Ch. May 26, 2017).
[12] See, e.g., In re Bioclinica, Inc., No. 8272-VCG, 2013 Del. Ch. LEXIS 250, at *23 (Del. Ch. Oct. 16, 2013).
[13] See, e.g., Ehrlich v. Phase Forward, Inc., Nos. 119227, MICV201001463C, 2010 Mass. Super. LEXIS 372, at *6 (Mass. Super. Ct. June 21, 2010); In re Netsmart Techs., Inc. S'holders Litig., 924 A.2d 171, 195-96 (Del. Ch. 2007).
[14] Genomic Health, 2021 Del. Ch. LEXIS 175, at *32, quoting Larkin.
[15] In re Columbia Pipeline Grp., Inc., No. 12152-VCL, 2021 Del. Ch. LEXIS 39, at *110-11 (Del. Ch. Mar. 1, 2021) (citations omitted).
[16] In re Tesla Motors, Inc. Stockholder Litig., No. 12711-VCS, 2020 Del. Ch. LEXIS 51, at *28 (Del. Ch. Feb. 4, 2020) (internal quotation marks and footnotes omitted).