Building on a body of jurisprudence that includes the Toys "R" Us (In re Toys "R" Us, Inc., S'holder Litig., 877 A.2d 975 (Del. Ch. 2005)) and Del Monte (In re Del Monte Co. S'holders Litig., 25 A.3d 813 (Del. Ch.2011)) decisions, the Kinder Morgan (In re El Paso Corp. S'holder Litig., 2008 WL 653845 (Del. Ch. 2012)) decision continues the Court of Chancery's guidance on how to best avoid the taint of a conflict of interest or undue influence without setting down a bright-line standard.
In an important exception to the business judgment rule, Delaware courts apply the enhanced fairness standard to actions by a board of directors with respect to a takeover or a change of control where there is any appearance of a conflict of interest (Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), Unocal v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985)). With Kinder Morgan the court has reiterated its established principles concerning how best to avoid perceived conflicts and resulting accusations that a transaction was not entirely fair. In addition, the court has somewhat refined the contours of those principles.
Full and Timely Disclosure
The Court of Chancery has emphasized the importance of early and full disclosure in both management buyouts and situations where advisers have relationships on both sides of a transaction. While disclosure will not fully cure any and all conflicts, it can have a cleansing effect and, perhaps more importantly, a lack of disclosure has been harshly criticized by Delaware courts. In Mills (Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261 (Del. 1989)), the Delaware Supreme Court wrote "there can be no dispute that such silence [is] misleading and deceptive." The decision in Kinder Morgan highlights the difficulty of implementing this disclosure; the parties involved were so interconnected -- there was an adviser with relationships on both sides of the deal, including ownership of a significant percentage of the shares of the buyer and seats on its board and a chief executive on the target side that was also considering buying part of the business back from the buyer after the acquisition closed -- that potential conflicts arose on a wide range of fronts. The failure of the target's chief executive to disclose these potential conflicts to his board of directors was sharply criticized by the Court of Chancery. In a management buyout, for example, disclosure by an executive to his board of directors of negotiations with a prospective buyer is key, and the earlier the better. Conversely, for investment banks and other advisers, any involvement with parties on both sides of a deal should be promptly and fully divulged to the companies involved in the transaction. In all cases, any party who runs the risk of being perceived as having a conflict of interest should recuse himself from the vote at which the deal is approved and should pair with other executives or advisers in negotiations.
A Robust and Independent Conflicts Protection Process
The importance the Court of Chancery has placed on disclosure of a potential conflict is due in part to the importance of such disclosure to other conflict protection mechanisms. In Del Monte, the Court of Chancery noted that, with more information, "the Board and its experienced counsel doubtless would have taken steps to protect the integrity of the process." In Kinder Morgan, the Court of Chancery lamented that the target company's "independent directors were not trusted with the information" that the CEO was considering a management buy-back of part of the business, weakening the conflicts protection process in place. Indeed, once a conflict has been identified, a strong and independent conflicts protection process should be put in place. In the case of management buyouts, takeovers or other situations where members of management risk a perception of a conflict of interest or undue influence on the deal process, a special committee of the board of directors, which includes only independent directors, should evaluate the deal points, without the involvement of any conflicted party. The Court of Chancery is unlikely to overturn the decision of a board of directors decided by independent directors, which has relied on a special and independent committee (See, for example, In re Orchid Cellmark Inc. S'holder Litig., C.A. No. 6373-VCN (Del. Ch. 2011). For investment banks or other advisers, the situation should be vetted through the adviser's conflicts review committee or similar body, which will advise as to how best to cure the potential taint of a conflict.
An Independent Third-Party Adviser
If an adviser is perceived to have a conflict of interest, bringing on an independent third-party adviser can help cure the taint of that apparent conflict. This is particularly important because, as the Court of Chancery made plain in Del Monte, if the adviser is found to have a real conflict of interest, the directors of the corporation can face a breach of their own fiduciary duties for failure to adequately oversee that adviser. In the Kinder Morgan decision, the Court of Chancery took into account the choice to bring on an independent adviser on the target side of the deal, but also closely analyzed the extent of that adviser's independence. Ideally, to ward off all suggestion of taint by conflict, the new adviser should be free to advise the board to entertain all possible options, including rejecting the bid, and the conflicted adviser should step away completely from one side of the deal.
The Open Question: An Unwaivable Conflict?
The intensely fact-specific decisions of the Court of Chancery leave open the question of whether certain conflicts rise to a level where no protection mechanism could cure the resulting taint. In Toys "R" Us, the Court of Chancery called the sell-side investment banker's offering of stapled financing "unfortunate" and allowed that it would have been "[f]ar better" if stapled financing had been avoided, but ultimately concluded that the appearance of a conflict did not have a "causal influence" on the board of directors' decision. In Del Monte, the Court of Chancery criticized the seller's investment bank's involvement with buy-side financing, but did not expressly exclude all such arrangements. And in Kinder Morgan, the Court of Chancery criticized the entire sale process, but ultimately declined to enjoin the shareholders' vote, since no other bidder for the target existed. In the absence of a more definitive standard, boards and advisers that might risk a perception of conflict can only take note of the Court of Chancery's cues as to how to avoid the censure of a conflict: full and timely disclosure, a robust conflicts review process and a truly independent third-party adviser.
This article was written by Steven Goldberg, co-chairman of Baker Hostetler's Transaction team, together with Partner Scott Weiser and Associate Alison Flynn. All are in the New York office.
Steven Goldberg, Partner, firstname.lastname@example.org
Steven Goldberg is a partner residing in Baker Hostetler's New York office and is co-chairman of the firm's Transactions Practice Team. He practices primarily in mergers and acquisitions, private equity, joint ventures and strategic investments. He has represented both publicly traded and privately held companies on transactional matters in a number of industries.
Scott Weiser, Partner, email@example.com
Scott Weiser's practice covers a wide range of general business and securities matters. He has advised clients with respect to mergers and acquisitions, securities offerings, licensing transactions, corporate governance, regulatory compliance and general corporate matters. His clients cover a broad spectrum of the market, ranging from large public to small private companies.
Alison Flynn, Associate, firstname.lastname@example.org
Alison Flynn's practice includes representing public and private companies in connection with mergers and acquisitions, private equity, cross-border transactions, credit and lending transactions, asset acquisitions and sales, and general corporate matters. She has represented public and private companies in transactions involving domestic and international companies in a broad range of industries, including manufacturing, professional services and energy.
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