The relationship between private equity firms and public companies has increased significantly in the last few years. Investors have actively assisted companies in their efforts to raise funding, to engage in merger and acquisition activity, and to become dynamically involved in the public markets. As this role has increased and deals between private equity firms and companies have become more frequent, some stockholders have expressed concern that companies have failed to provide adequate disclosure of deal terms, and the Delaware Chancery Court (the “Chancery Court”) has responded to this concern. In three recently published opinions, the Chancery Court criticized companies involved in private equity transactions for failing to provide adequate disclosures regarding deal terms. These rulings suggest that private equity firms need to be vigilant to ensure that any public company with which it may engage in a transaction properly provides sufficient disclosure regarding that transaction. Specifically, investors should ensure that companies make adequate disclosure regarding any material issues that may affect a stockholder vote on a proposed transaction.
Set forth below are three recent opinions issued by the Chancery Court highlighting the importance of full disclosure in connection with deals between companies and private equity firms.
In re: The Topps Company Shareholder Litigation. On June 14, 2007, the Chancery Court issued an opinion indicating that boards of directors must continue to make adequate disclosures to stockholders regarding the terms of going-private transactions led by private equity firms. In In re: The Topps Company Shareholder Litigation, the Chancery Court enjoined a shareholder vote on a merger between Topps and a private equity firm because the disclosures made by the Topps board of directors in connection with the merger were inadequate. Specifically, the court indicated that the board failed to disclose the bidding fund’s indication that it would retain existing management after the merger, and it failed to release a competing bidder from a standstill agreement that prevented the bidder from (i) publicly commenting on its negotiations with Topps; and (ii) making a non-coercive tender offer for Topps on terms favorable or more favorable than those that were offered to the Topps board of directors.
In the Topps case, a group of private investors, led by former Disney CEO Michael Eisner, submitted a bid to purchase Topps that envisioned the retention of the company’s pre-transaction management. The bid was submitted to Topps pursuant to an agreement that included a 40-day go-shop provision after the agreement was signed, and the agreement provided Topps the right to accept a “Superior Proposal.” Shortly before the merger agreement was signed, Topps’ primary competitor, The Upper Deck Company (“Upper Deck”), expressed interest and willingness to make a bid for the company. In spite of this interest, Topps proceeded to execute the merger agreement with the private equity firm, and during the go-shop period after execution, Upper Deck emerged as the only serious bidder.
Near the end of the go-shop period, Topps received a bid from Upper Deck that offered a higher price per share than the price per share offered by the private equity firm. In spite of the higher price per share offered, the Topps board did not consider the offer to be a “Superior Proposal,” which was a prerequisite to the private equity firm’s obligation to either match Upper Deck’s offer or step aside. Subsequently, Topps made public disclosures regarding Upper Deck’s offer that did not accurately represent Upper Deck’s expression of interest, and which disparaged the seriousness of Upper Deck’s offer.
After hearing the case, the Chancery Court held that the proxy statement issued by Topps omitted several material facts which should have been disclosed. The court indicated that the proxy did not include information regarding the private equity firm’s intentions to retain existing management, it failed to disclose material information about the competing bid, and it failed to disclose revisions made by the financial advisor who was analyzing the transaction to make the private equity firm’s bid seem more appealing.
The Chancery Court noted that boards of directors must continue to adhere to their fiduciary duties to stockholders. The court indicated that there was a reasonable probability that the Topps board of directors breached its fiduciary duties by using the standstill agreement to prevent Upper Deck from communicating with the Topps stockholders, and noted that “when directors bias the process against one bidder and toward another not in a reasoned effort to maximize advantage for the stockholders, but to tilt the process toward the bidder more likely to continue current management, they commit a breach of fiduciary duty.”
There are several important lessons that the Topps case provides. First, private equity firms need to encourage managers and boards of directors to make sure their proxy statements include adequate, full disclosure of deal terms. Information and facts about competing bids, as well as the financial analyses upon which boards and managers base their decisions, are material information and need to be incorporated in company proxies. In addition, companies must provide proxy disclosure that provides a full picture of a potential transaction. It is not acceptable to provide only a partial snapshot of the transaction; companies must provide enough information to enable stockholders to understand the entire picture. Finally, private equity firms and companies need to confirm that any standstill agreement permits the company to take action which is in the best interests of its stockholders, and not simply the best interests of management.
In re: Lear Corporation Shareholder Litigation. The Chancery Court issued a second opinion on June 15, 2007 that reinforces the principles set forth in Topps. In In re: Lear Corporation Shareholder Litigation, the court issued a limited injunction halting a shareholder vote on a proposed acquisition of Lear Corporation until additional proxy disclosure was made.
In this case, Lear’s CEO began negotiations with a private equity fund controlled by Carl Icahn. The CEO independently negotiated a going-private deal with Icahn, and subsequently a special committee of the board of directors was formed to oversee the merger process. This committee did not actively participate in the due diligence and merger negotiation process, but instead permitted the CEO to lead the negotiations. Lear eventually signed a merger agreement with Icahn which included a 45-day go-shop provision, an approximate $100 million termination fee, and a fiduciary “out” permitting Lear to accept a “Superior Proposal” after the end of the go-shop period. Lear chose to execute this deal instead of engaging in a formal public auction process.
The CEO who was negotiating the deal was Lear’s longest-serving executive, and he had accumulated substantial benefits under the company’s retirement program. Shortly before the going-private transaction negotiations began, the CEO had asked the Lear board to change his employment arrangement to allow him to cash in his retirement benefits while continuing to run the company. Subsequently, during the CEO’s negotiations with Icahn, Icahn agreed to employment terms that allowed the CEO to secure a short-term schedule for the payout of his retirement benefits, provided him an improved salary and bonus package, and granted him options that included a lucrative upside if Lear performed well after the merger.
The Chancery Court held that Lear’s proxy disclosing the transaction should have included additional information regarding the CEO’s negotiation with Icahn concerning his retirement benefits. The court indicated that “a reasonable stockholder would want to know an important economic motivation of the negotiator singularly employed by a board to obtain the best price for the stockholders, when that motivation could rationally lead that negotiator to favor a deal at a less-than-optimal price, because the procession of a deal was more important to him, given his overall economic interest, than only doing a deal at the right price.” Further, the court indicated that the Lear stockholders were entitled to know that the CEO had “material economic motivations that differed from their own that could have influenced his negotiations with Icahn.”
The court also suggested that the special committee created by the board to oversee the merger process could have been more involved in the negotiation process. The court indicated that it would have been preferable if the committee’s chairman or, at the very least, its lead banker, participated with the CEO in the negotiations with Icahn. This involvement would have at least provided some assurance that the CEO would have taken a tough line and avoided inappropriate discussions.
In re: Netsmart Technologies, Inc. Shareholder Litigation. In March 2007, the Chancery Court issued an opinion criticizing a board for deciding to limit its search for potential buyers to private equity firms only, and for failing to contact prospective strategic buyers. In In re: Netsmart Technologies, Inc. Shareholder Litigation, a special committee of the Netsmart board of directors undertook a limited auction of the company to several private equity firms. The company subsequently executed a merger agreement which prohibited the board from shopping the company, but permitted the board the right to consider a superior proposal, and which included a 3% termination fee. Certain Netsmart stockholders brought an action to enjoin the merger based on the fact that the company did not seek a strategic buyer, but instead focused on a rapid auction process that only involved a small set of possible private equity buyers.
The Chancery Court agreed with the plaintiff stockholders, holding that Netsmart did not have a reasonable basis for failing to undertake any exploration of interest by strategic buyers. The court indicated that the board’s assumption that a post-signing market check would stimulate a hostile bid by a strategic buyer, in the same manner it had worked to attract topping bids in large-cap strategic deals, had little basis in light of market dynamics relevant to the company. Noting that the company’s “sporadic” discussions with strategic buyers occurred when Netsmart was a much smaller company, the court concluded that the company did not participate in a “reliable market check.”
The Chancery Court also held that the disclosure in the Netsmart proxy was inadequate because it failed to include cash flow projections that were used by the company’s financial advisor. The court indicated that this information was important because the company’s stockholders were being asked to accept a one-time payment of cash and to forsake any future interest in the firm, and a reasonable stockholder would find it material to know the best estimate of the company’s expected future cash flows.
Lessons for the Future
The focus of Delaware courts has been, and continues to be, on process and reasonable decision making. In light of this focus, the following are the primary lessons to be taken from Topps, Lear, and Netsmart:
- Private equity firms should encourage boards and management to make full disclosures regarding deal terms to their stockholders that are not distorted or materially misleading. Incentives offered to negotiators, officers, and directors in connection with potential transactions must be disclosed to provide stockholders so that they have the information necessary to make a decision.
- Private equity firms should negotiate directly with board committees regarding possible merger and acquisition activity, and refrain from negotiating solely with a seller’s management.
- In the event a private equity firm intends to retain a target’s management after a transaction has closed, the investor should only begin negotiating employment terms with such management after the stockholder vote regarding the transaction has occurred. Private equity firms should also confirm that a target discloses in its proxy the investor’s intention to retain the target’s management.
- If a private equity firm and a target intend to execute a “Standstill Agreement” in connection with a transaction, this agreement should include carve-outs to permit the company to act in the best interests of their stockholders.
- Counsel, boards of directors, and special committees need to closely scrutinize transactions with private equity firms to ensure stockholders are provided a full picture of transaction terms and officer and director incentives.
- Committees supervising possible transactions should include at least one disinterested member, and should provide frequent reports to boards of directors. It may be advantageous to have this transaction committee made up entirely of independent directors.
- Boards of directors must continue to adhere to their fiduciary responsibilities to stockholders. It is important that boards prioritize these duties over the benefits that a board or management may personally receive in connection with a transaction.