By way of background, directors are subject to the duties of care and loyalty during their service to the corporation. In addition, with certain sale or merger transactions, directors are subject to additional so-called Revlon duties to ensure that reasonable efforts are made to secure the highest price reasonably available to the target. When a potential sale or merger transaction leads to a direct conflict in interests between preferred and common shareholders, directors must fulfill the contractual rights of preferred shareholders first. However, once these contractual rights have been satisfied, directors may favor the interests of common stockholders over preferred stockholders if the interests of the two constituencies differ.
Strategies that may be pursued to limit director personal liability for claims include a limitation of liability clause in the target’s certificate of incorporation (see for example, §102(b)(7) of the Delaware General Corporation Law), obtaining or increasing coverage of directors and officers liability insurance (D&O insurance), a “fiduciary out” in the transaction document, and the use of an independent committee of directors to evaluate any potential sale or merger. Let’s look at some of these scenarios.
The business and affairs of a corporation are generally managed by the corporation’s directors. In performing those duties, directors must abide by the duties of care and loyalty, as spelled out in a 1986 case, Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. These are usually referred to as “Revlon duties.” The duty of loyalty requires that a director put the best interests of the corporation above his or her own personal interests. The duty of care requires that a director perform his or her duties in the manner that an ordinarily prudent person would in a similar situation.
Directors of a Delaware corporation may be exculpated from violations of the fiduciary duty of care if the corporation has a §102(b)(7) provision in its certificate of incorporation. Section 102(b)(7) of the Delaware General Corporation Law provides that a corporation may limit the personal liability of a director for monetary damages for breach of a fiduciary duty as a director, except in cases where 1.) the director breaches the duty of loyalty to the corporation or its shareholders, 2.) the director participates in acts or omissions not in good faith or which involve knowing or intentional misconduct or 3.) the director engages in a transaction in which the director obtained an improper personal benefit.
When directors are faced with a potential sale or merger transaction, their decisions are generally subject to the “business judgment rule.” This rule presumes that directors making a business decision “acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” Quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). Delaware courts will not substitute their own judgment for that of the board of directors if a board decision can be “attributed to any rational business purpose.” Quoting Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 954 (Del. 1985).
There are three situations in which Revlon duties will attach: 1.) when a company initiates an active bidding process to sell itself or breakup the company, 2.) following a bidder’s offer, the target abandons its long-term strategy and seeks a transaction that will result in the breakup of the company and 3.) when a proposed transaction will result in a change of control. See In re Smurfit-Stone Container Corp. Shareholder Litigation, C.A. No. 6164-VCP, at 30-31 (Del. Ch. May 20, 2011).
In these situations, the duty of the directors is not to preserve the corporate entity, but to maximize the sale value of the corporation for the benefit of the company’s shareholders. The fact that the board must consider Revlon duties does not prevent the directors from engaging in defensive measures such as lock-ups, but these defensive measures must elicit bidders. Delaware courts have made it clear that there is no particular process to value maximization that must be followed to meet the requirements of Revlon. See In re Dollar Thrifty Shareholder Litigation, 14 A.3d 573, 595 (Del. Ch. Sept. 8, 2010). So long as the target corporation has an independent, well-informed board acting reasonably and in good faith to maximize value, a court will not substitute its judgment for that of the board of directors.
When a director is considering a sale or merger transaction in which the interests of the common and preferred shareholders diverge, special care must be taken. If there are specific contractual provisions that specify what a preferred shareholder’s rights are, the board must abide by those rights alone — the board is not required to give further benefits to the preferred shareholders above and beyond such contractual provisions. Thus, as long as any contractual obligations are satisfied, preferred shareholders will typically have no claim for breach of fiduciary duty against a director. Nemec v. Shrader, 991 A.2d 1120, 1129 (Del. 2010).
However, when there are no specific contractual provisions that detail a preferred shareholder’s rights in a sale or merger, the board of directors must attempt to “do its best to fairly reconcile the competing interests of the common and preferred” shareholders. LC Capital Master Fund, Ltd. v. James, C.A. No. 5214-VCS, at 22-23 (Del. Ch. Mar. 8, 2010).
Issues most often arise in sale and merger transactions where corporations have both common and preferred stockholders and the transaction consideration is not allocated equally among the classes. The most heightened scenario is when preferred shareholders receive all or a significant portion of the consideration pursuant to their contractual rights and common shareholders receive little or no consideration. Particularly in these circumstances, all or certain of the following protective measures should be taken to protect the directors of a target’s board from successful claims of breach of fiduciary duty:
- Reallocate a portion of the merger consideration from the preferred to the common stockholders so that the common stockholders receive some merger consideration. This will obviously require the consent of those classes of stock adversely impacted. When implementing the reallocation, include a reference in the certificate of incorporation of the target that it is subject to the “transaction documents.” In the transaction documents, recipients of merger consideration agree to release the target and its directors from claims. If not already there, include a “§102(b)(7)-type” provision in the target’s certificate of incorporation. This will not exculpate directors for breaches of the duty of loyalty, but it will help protect against alleged violations of the duty of care.
- Make sure the target corporation has appropriate D&O insurance coverage. If coverage needs to be increased, have this be a condition to signing rather than closing in case claims arise between signing and closing.
- Obtain a fairness opinion. Ideally, this would be from an independent banker rather than the banker involved in the transaction and would include opinions of fair value for each class of stock rather than an opinion that the “entire” transaction is fair from a financial point of view.
- Fiduciary claims are separate and distinct from dissenters/appraisal rights. Therefore, even if a security holder has not asserted its dissenters/appraisal rights and has received merger consideration, he or she is not barred from asserting a breach of fiduciary obligation claim. The statute of limitations for fiduciary claims varies from state to state so be sure to negotiate a survival period for breach of fiduciary duty claims that is at least as long as the statute of limitations.
- Where security holders appoint the target’s directors and such security holders have an obligation to indemnify such directors pursuant to contract or other governing documents, require indemnification from such security holders to the extent such indemnity amounts are not otherwise covered by insurance.
- The transaction document should provide that the target’s board has a “fiduciary-out” if it gets a better offer between signing and closing. Negotiate a market break-up fee and no-solicit provisions so that the buyer is protected but the target can continue to receive bids.
- Thoroughly document the process and motivations of the board so there will be a greater chance the business judgment rule will not be rebutted. Use a reputable investment banker in the target’s industry to “shop” the target. Document that the target exhausted other possibilities before accepting an offer where certain security holders take a haircut — for example, current and new investors are unwilling to invest additional funds and traditional financing avenues have been exhausted.
- If possible, make sure directors are common shareholders rather than preferred shareholders. Courts have found that in transactions where the interests of common and preferred shareholders diverge and the common shareholders file a claim, directors who own preferred stock may be interested, while directors who hold common stock are usually not interested. If the board is composed of a majority of directors with ties to the preferred shareholders rather than common shareholders, appoint a special committee to review the transaction on behalf of the common shareholders.
An issue related to breach of fiduciary claims, but one that is beyond the scope of this article, is whether a buyer can be held liable for aiding and abetting the target corporation’s board in connection with its breach of fiduciary duty. In order to prevail on this claim, a plaintiff must prove that 1.) there was a fiduciary relationship between the security holder and the target’s board, 2.) the duty was breached and 3.) the buyer knowingly participated in that breach. Delaware courts have stated that a third-party bidder negotiating at arms’ length with the target corporation will rarely be liable for aiding and abetting. See In re Del Monte Foods Co. Shareholders Litigation, 2011 WL 532014, at 20 (Del. Ch. Feb. 14, 2011). Despite this, a potential acquirer may be liable to the shareholders of the target corporation if the bidder and the target board “conspire in or agree to the fiduciary breach.” Id. at 21.
Potential acquirers are permitted to negotiate a lower price through arms’ length dealings with the target board, but the bidder is not permitted to exploit a target’s fiduciary breach by demanding terms that force the target board to prefer its own interests over the interests of the target’s shareholders.
Jennifer L. Vergilii is a partner in Calfee, Halter & Griswold’s M&A practice group. Her practice focuses on counseling publicly and privately held clients with respect to a wide range of general corporate and business matters as well as mergers and acquisitions. She can be reached at 216.622.8568 or [email protected].