What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies

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1 By in-house counsel, for in-house counsel. InfoPAK SM What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies Sponsored by: Association of Corporate Counsel 1025 Connecticut Avenue, NW, Suite 200 Washington, DC USA tel , fax

2 2 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies July 2011 Provided by the Association of Corporate Counsel 1025 Connecticut Avenue, NW, Suite 200 Washington, DC USA tel fax This InfoPAK SM is to assist corporate counsel in understanding and making decisions about private class action litigation typically brought by shareholders following the announcement of a strategic transaction, generally a merger or acquisition, by a public company. Included is a summary of the types of claims that are most frequently brought by shareholders. It discusses what claims to expect and how these claims are typically resolved. It also summarizes the most common issues that are litigated as a part of this type of merger litigation. The information in this InfoPAK should not be construed as legal advice or a legal opinion on specific facts and should not be considered representative of the views of Morrison & Foerster LLP or of the ACC or any of its lawyers, unless so stated. This InfoPAK is not intended as a comprehensive or definitive statement on the subject, but rather serves as a resource identifying areas that require evaluation and providing practical information for the reader. This material was compiled by the securities litigation and mergers and acquisition groups at Morrison & Foerster LLP, the 2011 Co-Sponsor of the ACC Litigation Committee. For more information about Morrison & Foerster, visit or see the About the Authors Section of this document. The ACC wishes to thank the members of the Litigation Committee for their contributions to the development of this InfoPAK. Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

3 3 Contents I. Overview... 6 II. Trends in Deal Litigation... 6 III. Legal Challenges to the Deal... 7 A. The Fiduciary Duties of Directors Generally Applicable Fiduciary Duties Special Duties Arising in the Change-of-Control Context... 9 B. Judicial Scrutiny of Board of Directors Decisions The Business Judgment Rule Enhanced Scrutiny The Entire Fairness Test C. Recurring Challenges to Deals Allegations of Unfair Price Allegations of Conflicts of Interest Allegations that the Board Used an Unfair Process Allegations of Unreasonable Deal Protection Devices Transactions with Controlling Shareholders Allegations of Misleading or Inadequate Disclosures Federal Claims Regarding Acquisitions IV. Procedural Issues Arising at the Outset of Deal Litigation A. Who Will Sue? Likely Plaintiffs and Defendants Plaintiffs Defendants B. Determining the Forum Why Venue Fights are So Common in Deal Litigation Options When Lawsuits are Filed in Multiple Locations Forum Selection Clauses V. Motions for Preliminary Injunctions A. Practical Considerations When a Preliminary Injunction is Sought... 37

4 4 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies 1. Expedited Proceedings and Scheduling Expedited Discovery B. Standards for Granting a Request for Injunctive Relief Plaintiffs Probability of Success on the Merits Irreparable Harm Balance of the Hardships The Bond Requirement VI. Class Certification A. Rule 23(a) B. Rule 23(b) C. Opt Out Versus Non-Opt Out Classes VII. Post-Closing Litigation A. The Effect of Appraisal Statutes B. Impact of Exculpation Provisions DGCL Section 102(b)(7) C. Impact of the Shareholder Vote D. Motions to Dismiss and for Summary Judgment E. Calculation of Damages VIII. Indemnification and Insurance A. Indemnification B. Insurance IX. Settlement A. What Consideration Will Support a Settlement? Supplemental Disclosures Changes to the Deal s Terms Increased Consideration in the Deal A Common Fund B. Class Certification and Notice C. Releases D. Court Approval X. Attorneys Fees Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

5 5 A. Bases of an Award of Attorneys Fees B. When and How Is the Issue Resolved? XI. About the Authors XII. Additional Resources A. ACC Resources B. Outside Resources XIII. Sample Forms A. Litigation Document Hold Notice B. Sample Protective Order C. Deal Litigation Checklist XIV. Endnotes... 77

6 6 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies I. Overview In the past several years, investor class actions have become an almost inevitable aspect of mergers and acquisitions involving public companies. In federal court (where statistics are available) such claims increased 471% from 2009 to This InfoPAK aims to provide corporate counsel with a practical guide to deal litigation. 2 It is divided into five major sections. First, we provide a short summary of some recent trends in deal litigation, including the increase in litigation activity in this area, the substantive focus on conflicts of interest affecting directors and their advisors, and the increasing scrutiny of settlements. Second, we address the different legal duties that arise during mergers and acquisitions and the different levels of scrutiny that courts apply to board decisions during litigation. We then discuss how courts address the particular issues that arise most frequently in deal litigation. Third, we provide an overview of the nuts and bolts procedural issues that arise when plaintiffs lawyers seek to enjoin a deal. These include a review of the players in the drama, the battles over venue, the rules governing expedited discovery and proceedings, and some of the tactics that are often employed at this stage of proceedings. Fourth, we review some of the more important issues that arise when deal litigation extends beyond the closing of the deal. These include defenses available to directors, such as the exculpatory provisions in most corporate charters, the methods of calculating damages, and the procedural devices available to defendants, such as motions to dismiss or for summary judgment. Fifth, we address several issues that can arise throughout the litigation process, including insurance, indemnification, and settlement. We have also included items that we hope will be of use in an appendix to the main document. These are a Deal Litigation Checklist (App. A); a sample Litigation Document Hold Notice (App. B); and a sample Protective Order (App. C). We have focused on Delaware law because so many public companies incorporate there and because many other states often look to Delaware courts for guidance in this area. It is important to note, however, that many corporations are incorporated elsewhere, and the laws of other jurisdictions may differ from Delaware law in significant respects. This InfoPak does not seek to provide a comprehensive analysis of all the issues that arise in deal litigation, and we have simply sought to identify the important issues and provide guidance on how they are often resolved. Our hope is that it will make you a more knowledgeable consumer and a more effective partner with your mergers and acquisitions lawyers and your litigation team. II. Trends in Deal Litigation Merger litigation is on the rise. As discussed above, filings were up from 2009 to 2010 and over the last decade. This increase reflects both that more deals are being challenged and the increasing number of deals challenged in more than one venue. The proliferation of cases across the country and the rise of multijurisdictional challenges for mergers complicates efforts to defend against or Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

7 7 resolve merger cases. These cases often require more lawyers in more places and more careful coordination both before and after a transaction closes. Given the rise in numbers and locations, corporate counsel should make sure that they make defense of merger litigation a part of their overall strategy for completing a merger or acquisition. A second trend is a continued focus on an old theme: conflicts of interest. Under the business judgment rule and similar doctrines, U.S. corporate law provides directors wide leeway when making decisions, including where, when, and under what terms to engage in strategic transactions. This deference may, however, be set aside when a plaintiff can make a well-founded case that players critical to a transaction suffer from meaningful conflicts of interest. At the same time, courts in Delaware and elsewhere are evaluating the extent to which the use of special committees, majority of the minority voting requirements, and other procedural safeguards eliminate the need for heightened judicial review under the entire fairness standard. Naturally, concealed conflicts of interest create the greatest risks. Full disclosure and careful evaluation by independent, disinterested directors using independent advisors remains an important method for curing the effect of a potential or actual conflict. While the most serious conflicts are those that affect the conduct of directors, majority shareholders, or the chief executive officer (particularly when the CEO plays a significant role in merger negotiations), conflicts affecting the work of financial and other advisors may also increase the probability of more intrusive judicial scrutiny. Some relationships that may be perceived as conflicts between a company s representatives and other third parties may provide a significant benefit for the company and its shareholders during negotiations or when the company tries to identify additional interested parties. What is vital is that directors understand any significant relationships or conflicting incentives and evaluate their potential effects, both positive and negative, on negotiations, on the transaction or on litigation. Thus, prudent counsel looks for potential conflicts early and stays alert throughout the transaction. Finally, some judges have been subjecting settlements to increased scrutiny to determine whether they convey any real benefit on the class. Courts are taking more opportunities to evaluate cases earlier, to examine settlements with more care, and to criticize parties when the settlements are not justified by the consideration provided. Because deal litigation, like most forms of litigation, frequently ends in settlement, corporate counsel would be wise to talk in advance with their outside counsel about how recent events have influenced this trend and how these events may affect where, how, and how soon any potential or actual litigation may end. III. Legal Challenges to the Deal The discussion below provides a guide to how most courts, including the Delaware Court of Chancery, are likely to address the most important issues in deal litigation. One must keep in mind, however, that the Delaware Court of Chancery, where much of the law in this area has developed, is a court of equity, which aims to render reasonable, practical, and fair decisions appropriate for the facts of a particular case. Other courts, too, generally sit as courts of equity in evaluating corporate disputes. Judges have more flexibility in equity than when they sit as courts of law. When applied to the conduct of corporate fiduciaries, the law and remedies are intentionally flexible and designed to prompt an evaluation of each case on its individual facts. Thus, it is recommended that you identify and possibly coordinate with local counsel who is familiar with this area of law and with the judges applying it. For more ACC InfoPAKs, please visit

8 8 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies A. The Fiduciary Duties of Directors Directors are fiduciaries entrusted with the power and responsibility to supervise a corporation s business affairs and obligated to act in the best interests of the corporation and its shareholders. 3 In so doing, directors are required to fulfill duties of care and loyalty. Those duties apply in all contexts, including decisions regarding mergers and acquisitions. When dealing with a sale or change of control of a Delaware corporation, directors have additional obligations to perform their duties of care and loyalty in a manner that maximizes shareholder value. 1. Generally Applicable Fiduciary Duties a. The Duty of Care The duty of care requires directors to make decisions on an informed and good-faith basis following consideration of reasonably available relevant information, including, where appropriate, the advice of advisors and management. 4 In making decisions, directors must use the amount of care that ordinarily careful and prudent people would use in similar circumstances. 5 Directors may delegate day-to-day management and tasks to corporate officers and other corporate agents. With certain exceptions, an informed decision to delegate a task to management (or others) is as much an exercise of business judgment as any other. 6 Directors can and often must rely on reports and recommendations from board of director committees, officers, employees, professionals, and experts selected with reasonable care. 7 A director breaches the duty of care when acting with gross negligence. Gross negligence is conduct that is without the bounds of reason, manifests reckless indifference to a matter, 8 or constitutes willful blindness. 9 b. The Duty of Loyalty A director s loyalty must be undivided and free from the taint of a material conflict of interest. 10 A director must act in good faith, comply with the law, and deal honestly and fairly with the company s shareholders. 11 Directors cannot use their position of trust and confidence to further their private interests. 12 Examples of disloyal conduct include: Stealing an opportunity belonging to the corporation; Improperly using or sharing confidential information; Insider trading; and Using the position to get a material benefit not shared with other shareholders, including acting to benefit an executive or other director to whom the director may appear to be beholden. 13 A director must act to promote the interests of shareholders, and cannot act to promote nonshareholder interests, such as those of employees, unless those acts ultimately enhance value for the shareholders. 14 Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

9 9 c. Related Responsibilities i. Disclosure Obligations The duties of care and loyalty require directors to provide fair and candid disclosure to shareholders. 15 This is sometimes discussed as a duty of candor on the part of directors and officers. Whenever directors elect to communicate with investors for any purpose, they must do so honestly. 16 Whenever directors seek shareholder action, such as in connection with a shareholder vote or tender offer, they must disclose fully and fairly all material information within the board s control. 17 Directors who knowingly disseminate materially misleading information breach their fiduciary duties and may separately be subject to liability under the federal securities laws. 18 Information is material if there is a substantial likelihood that a reasonable shareholder would consider information important in deciding how to vote. 19 Directors are not required to disclose every fact or detail regarding a subject. Indeed, courts recognize that shareholders do not benefit by being buried in an avalanche of trivial information. If disclosures are too detailed and voluminous, they will not serve their intended purposes. 20 Materiality thus presents a very important limiting consideration with respect to what directors need to disclose, which is discussed further below. ii. Oversight The duties of care and loyalty also require directors to exercise oversight over corporate affairs. 21 The failure to do so can give rise to personal liability in at least two circumstances: (1) when directors utterly fail to implement any reporting or information system or controls; and (2) when directors, having implemented such a system or controls, consciously failed to monitor or oversee its operations. 22 In either circumstance, only a sustained or systematic failure of the board to exercise oversight will establish the lack of good faith that is a necessary condition of liability under the Caremark standard. 23 To prove a violation of this duty, plaintiffs must identify conduct that is roughly equivalent to a bad faith refusal by directors to do their job Special Duties Arising in the Change-of-Control Context Under Delaware law, directors have special obligations in connection with a transaction involving a sale or change of control of the corporation. These special obligations are called Revlon duties after the Delaware Supreme Court s landmark case, Revlon Inc. v. MacAndrews & Forbes Holdings, Inc. 25 Where Revlon duties apply, directors must perform their duties of care and loyalty in the service of a specific objective: maximizing the sale price of the enterprise. 26 Revlon requires that directors implement a process that is reasonably designed to secure a transaction that offers the best value for the shareholders, regardless of whether it is in the long-term best interests of the combined corporate entity. 27 Many jurisdictions for example, Nevada and Ohio, which like Delaware, generate many out-of-state incorporations do not impose Revlon-type duties on directors. 28 In these and similar jurisdictions, the merger is reviewed primarily based on the fiduciary duties discussed above in light of the business judgment rule or the entire fairness standard as discussed below. Given the significance such duties can play in litigation, it is good to determine early on whether Revlon duties will apply to your company s specific circumstances. For more ACC InfoPAKs, please visit

10 10 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies a. When Revlon Applies Delaware has held that Revlon duties arise in the following circumstances: When a corporation initiates an active bidding process to sell itself; When a company abandons its long-term strategy in response to a bidder s offer by seeking an alternative transaction that involves breaking-up the company; or When a company otherwise pursues a sale of control. 29 The most common of the three enumerated circumstances is a sale of control. Generally, a sale of control arises at least when shareholders will not retain any ongoing long-term interest in the company s business after the transaction, such as a corporate break-up or cash-out merger or similar transactions in which shareholders do not obtain rights as an equity holder in the new entities created by the transaction. 30 Therefore a sale of control for purposes of the third category does not occur where control of both companies before and after the merger remains dispersed among a wide variety of shareholders in a large, fluid, changeable and changing market, such as a transaction involving a stock-for-stock merger between equals, 31 and may not arise where merger consideration consists of a combination of cash and stock (depending on the particular mix and other factors). 32 Revlon duties do arise, however, when the shareholders exchange their shares for shares of a company that is dominated by a single entity or person. In Lyondell Chem. Co. v. Ryan, the Delaware Supreme Court clarified that the Revlon duty applies only when a company embarks upon a transaction on its own initiative or in response to an unsolicited offer that will result in a change of control. 33 Until the board of directors decides to actively pursue a change-of-control transaction, directors can assume a wait and see approach with respect to activities of third parties or reject an unsolicited offer without triggering new obligations under Revlon. 34 The board of directors can also investigate indications of interest or other potential transactions, essentially testing the waters, without triggering Revlon duties. 35 Once, however, a board of directors commits itself to a sale transaction that meets the criteria discussed above, the directors must thereafter pursue a process designed to seek the best value reasonably available for the company and the final agreement will be reviewed with Revlon duties in mind. Although the determination of whether Revlon applies is fact-specific, the following checklist provides a general guide: Transaction or Decision All-cash transaction with third party Transaction involving a combination of cash and stock Transaction with a third-party public company that has a controlling shareholder, even if for allstock consideration Does Revlon apply? Yes Maybe Yes Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

11 11 Transaction or Decision Stock-for-stock merger of equals Company-initiated reorganization that breaks up the company Receipt of an unsolicited merger proposal Rejection of an unsolicited offer Does Revlon apply? No Yes No No b. What Revlon Requires If Revlon applies, a board of directors must pursue a reasonable process designed to maximize the value shareholders will receive. 36 The board of directors need not necessarily accept the offer with the highest price, however, to satisfy its Revlon duties. Other material terms, including the likelihood that a transaction will close and the certainty of the consideration offered, are highly important considerations. 37 Courts often reiterate that there is no single blueprint directors must follow to maximize shareholder value and that directors are not required to conduct an auction according to some formula. 38 Instead, the board of directors must be reasonable in its approach. In some circumstances, directors may have reliable evidence with which to evaluate the fairness of a transaction without a further check of the market, in which case they may approve that transaction without evaluating alternatives. 39 Often, however, it is appropriate to seek outside information regarding the potential market for the company to confirm the value presented by the proposal that the board of directors is considering. There are several non-exclusive but typical techniques that boards of directors employ, with the assistance of financial advisors, to evaluate the market: For example, a board of directors can conduct a closed auction after the company makes a public announcement that it is for sale. Prospective bidders submit an offer by a fixed deadline following an opportunity to conduct some due diligence and a review of draft deal terms. Alternatively, a board of directors can conduct a more discrete or targeted pre-signing market check before signing a merger agreement by contacting potential buyers identified by the board and its advisors to evaluate what other parties might be interested in a transaction with the company. A company may decide in connection with the process whether and to what degree to make this process known publicly. The pre-signing market check aims to identify multiple potential acquirers and to identify any better offers before any legal commitments have been made. As a third alternative, a board of directors might use various types of post-signing market checks. Such checks can be passive, where the board does not seek out other potential bidders but allows such bidders to approach them, relying on the publicity inherent in the announcement of the signed acquisition agreement, or they can be more For more ACC InfoPAKs, please visit

12 12 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies active, such as in a go-shop, where the target solicits other potential suitors to investigate the company and submit bids (as discussed in Part III(C)(4)(b) below). The scope and nature of the actions that can be used to address a board of directors Revlon duties are almost limitless, and each transaction is judged in its own unique circumstances. Directors decisions will be examined with the broader goal in mind was the board of directors process reasonably designed to maximize value to shareholders? B. Judicial Scrutiny of Board of Directors Decisions There are three standards of review that courts apply when evaluating deal transactions challenged in litigation: (1) the business judgment rule; (2) enhanced scrutiny; and (3) entire fairness. 40 The standard of review applied to a given transaction can significantly affect the risks and costs of litigation. 1. The Business Judgment Rule The business judgment rule is the default standard of review. 41 The rule creates a presumption in litigation that in making a business decision the directors of a corporation 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. 42 When the business judgment rule applies, courts will not evaluate the substantive merits of a decision made. 43 A plaintiff can overcome the business judgment rule by providing evidence that a majority of directors, in reaching a challenged decision, were grossly negligent, acted in bad faith, or engaged in a self-interested transaction Enhanced Scrutiny In Delaware, the business judgment rule does not automatically apply, in the first instance, to business decisions involving: (1) a sale of control, a change of control, or a break-up of the company; or (2) the adoption of defense mechanisms in response to a threat to corporate control or policy. In these situations, the courts usually will apply an intermediate standard of review called enhanced scrutiny. The enhanced scrutiny standard exists to ensure that directors act with scrupulous concern for fairness to shareholders. 45 While the amount of scrutiny increases, it is worth noting that boards of directors retain broad discretion when deciding how to pursue a transaction and on what terms so long as they are acting in the best interests of shareholders and act reasonably to achieve this goal. a. Sales and Change-of-Control Under Revlon One form of enhanced scrutiny arises under Revlon, which is discussed above. When Revlon duties apply, a Delaware court will evaluate directors conduct to see if they acted reasonably to maximize value under the circumstances of the specific transaction. Directors should be in a position to show that they adequately informed themselves and used reasonable steps to evaluate how the transaction compares to other potential options, including other potential deals that might be available or not doing any deal. 46 Further, courts will evaluate whether the substantive decision reached was reasonable. 47 Nonetheless, the board of directors actions do not need to be perfect and do not need to locate the highest possible price. Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

13 13 Where a board of directors selects one of several reasonable alternatives, courts will generally not second-guess that choice even though the court might have decided otherwise. 48 What typically drives an adverse finding is evidence of self-interest, unexplainable favoritism, disdain towards a particular bidder, or similar conduct that is not motivated by an effort to benefit shareholders and therefore calls into question the integrity of the board of directors process. 49 b. Defensive Measures Under Unocal Enhanced judicial scrutiny also applies when a company adopts defensive measures, such as poison pills or another corporate action that may deter a bidder s takeover efforts. Rejection of an unsolicited acquisition offer, standing alone, is not considered defensive action subject to enhanced scrutiny. 50 Enhanced scrutiny will apply however when a board of directors adopts a corporate measure specifically to deter other known or unknown parties, including when such measures are adopted to protect a transaction to which the company has agreed. 51 Various types of defensively adopted deal-protection measures are discussed in more detail in Part III(C)(4) below. Courts evaluate defensive measures under the enhanced scrutiny standard articulated by the Delaware Supreme Court in Unocal Corp. v. Mesa Petroleum Co. 52 Under Unocal, directors have the initial burden to justify defensive measures. Courts evaluate a board of directors responses collectively as a unitary response to a perceived threat. 53 The board of directors must show both of the following: (1) that it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed ; and (2) that its action taken in response to that threat is neither preclusive nor coercive and is reasonable in relation to the threat posed. 54 The first requirement looks at the process leading to the board of directors decision. The second requirement looks at the substance of the decision. Delaware courts have recognized a wide variety of circumstances as constituting a legitimate threat to corporate policy, including, in some cases, price considerations or procedural tactics that might coerce shareholders decisions. Success where Unocal applies requires careful identification by the directors of the threat being addressed and a careful evaluation of how a specific response is proportionate to this threat. Here, the advice and assistance of financial and legal advisors is key. 3. The Entire Fairness Test The most exacting standard of review applied to directors decisions is the entire fairness standard. It typically applies: Where a plaintiff overcomes the presumption of the business judgment rule, as when a majority of directors face a conflict of interest; Where a board of directors fails to meet the Unocal or Revlon standard; or In connection with certain transactions in which a controlling shareholder is buying out minority shareholders. 55 The entire fairness test puts the burden on defendants to demonstrate both fair dealing and fair price. 56 A court s analysis of fair dealing focuses on the process that led to a transaction from initiation to final approval. 57 Fair dealing may be shown, for example, where a special committee approves For more ACC InfoPAKs, please visit

14 14 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies a transaction with the assistance of independent advisors following informed, thorough, deliberate and arms-length negotiations over a reasonable period of time. 58 Fair price focuses on the economic and financial considerations of the proposed transaction. 59 A fair price does not necessarily mean the highest price possible or the highest price that a fiduciary could afford to pay. 60 Rather, a fair price is one that a reasonable seller, under all of the circumstances, would regard as within a range of fair value. 61 Courts do not independently consider the fair price and fair dealing prongs of the entire fairness test. Rather, the entire fairness standard is a unitary inquiry that evaluates all aspects of the transaction. 62 C. Recurring Challenges to Deals 1. Allegations of Unfair Price Shareholders frequently assert that merger consideration represents an unfair price that resulted from an unfair process. Claims regarding price, while rarely sufficient standing alone to sustain a claim, often prove to be a focal point of litigation that gives rise to related claims regarding how transactions were negotiated, approved, and disclosed to shareholders. The board of directors must evaluate the adequacy of the price offered in any transaction, and frequently relies heavily on its financial advisor to do so. Financial advisors typically use a variety of methods to evaluate the adequacy or fairness of consideration offered in a transaction, including, for example, discounted cash-flow analysis; comparison to the market valuation of comparable companies; and comparison to the prices (or premiums over market price) in comparable transactions. These and other valuation methodologies are tools, which are only as reliable as the inputs used. Therefore, plaintiffs who challenge the fairness of merger consideration often claim that there were flaws with respect to the selection of inputs, including the methodologies, assumptions, and data underlying cash-flow forecasts, the risk premiums used, discount rates selected, and comparability of other companies or transactions reviewed. Using different inputs and assumptions, plaintiffs and their hired experts often present alternative analyses that make a company appear more valuable than the merger consideration proposed. 63 Except in the case of a transaction subject to review for entire fairness, there is no cause of action based solely on a showing that the price was too low. 64 Rather, plaintiffs can only pursue a claim where the actions of the directors or others associated with the transaction violate a fiduciary duty due to conflicts of interest, improper processes, or other circumstances discussed below. Nevertheless, analysis of price is often critical because plaintiffs use it to suggest directors must have violated their fiduciary duties by accepting such plainly inadequate consideration. 2. Allegations of Conflicts of Interest a. Director Conflicts Plaintiffs routinely challenge a transaction based on claims that directors had conflicts of interest or were dominated by others with such conflicts. An alleged conflict will not strip a decision of the business judgment rule s protection unless self-interested directors: Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

15 15 1. Constitute a majority of the board of directors; 2. Control and dominate the board of directors as a whole; or 3. Fail to disclose their interests in the transaction in a situation where a reasonable member of the board of directors would have regarded the existence of the material interest as a significant fact in the evaluation of the proposed transaction. 65 A decision tainted by any of these three circumstances will be subject to the entire fairness standard. 66 A director is considered interested in a decision when the director has divided loyalties, receives a material personal benefit that is not shared equally by all shareholders, or makes a decision to avoid a materially detrimental outcome as to the director (but not the company or its shareholders). 67 Various types of conduct may render a director interested, including, for example: Relationships with the company or third parties that benefit the director individually, such as where the director has an outside business interest with the company or a potential acquirer; Sales or purchases between the corporation and the director or entities in which the director has a material interest; A substantial ownership or other economic interest in the buyer; Engaging in unlawful insider trading; Seizing an opportunity belonging to a corporation; and Misusing corporate assets for personal gain. 68 Situations in which courts have declined to find a disabling conflict of interest include: Receipt of directors fees; 69 Anticipated board memberships in a merged entity; 70 Personal or past business relationships with someone with a conflict that does not affect the director s judgment; 71 Common equity interests in the seller; 72 or Nomination or appointment to the board by a particular shareholder or another fiduciary. 73 Courts have explained that equity ownership in the selling company gives the insiders an incentive to increase the value of the company s shares and aligns their interests with the shareholders interests. 74 A lack of independence can be shown by demonstrating that a director is so under the influence of For more ACC InfoPAKs, please visit

16 16 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies another person that his or her discretion is sterilized. 75 Conflicts may arise, for example, when an individual serves as a director of two entities that are contemplating a transaction with each other. Directors may be considered interested in circumstances where they act disloyally to benefit a certain group or class of shareholders who designated them to serve on a board of directors, as illustrated by the Delaware Court of Chancery s decision in In re Trados, Inc. Shareholders Litigation. 76 The court held that the plaintiff overcame the presumption of the business judgment rule by demonstrating that a majority of directors approved a transaction that favored a group of preferred shareholders, who had designated them to sit on the board of directors. While that fact alone did not render the directors interested, the same directors also had financial and employment-related interests with the various preferred shareholders that, when combined with their status as designated directors, compromised their neutrality. 77 Plaintiffs have also argued that conflicts can arise where directors approve a transaction that results in the extinguishment of derivative claims against them. Recently, the Delaware Supreme Court in Arkansas Teacher Retirement System v. Caiafa, confirmed that derivative claims will only survive a merger that is undertaken to deprive shareholders of litigation standing, but made clear that directors have no duty to undertake a valuation of pending derivative claims against themselves when considering the fairness of merger consideration. 78 The Caiafa court held that no disabling conflict of interest arises in such circumstances. Delegation of decision making to special committees composed of independent directors can be useful when actual or potential conflicts could taint a board of directors decision. Delegation to special committees can confer significant legal benefits to all board members, depending on the transaction or decision in question. Where a majority of the members of a board of directors lack independence or have a disqualifying interest, delegation to a special committee may subject the transaction to review under the business judgment rule rather than under the more onerous entire fairness standard that would otherwise apply. In the case of a transaction with a controlling shareholder, delegation to a special committee may not be sufficient to retain the benefit of the business judgment rule, but can confer various benefits discussed below in Part III(C)(5). 79 A special committee s decision will be respected only if the special committee operates effectively. A special committee will be considered effective if it is active and well informed, independent, has a clear understanding of its mandate, and has real bargaining power. 80 To be independent, the special committee should consist of directors who are disinterested and independent with respect to the transaction or decision at issue. The committee s mandate and powers should be described clearly in writing. The committee should be empowered with real bargaining power and should have the power and ability to say no to a transaction involving a conflicted fiduciary. A special committee should consider retaining its own independent financial and legal advisors without influence from management or conflicted fiduciaries and ensure that the selected advisors have the necessary experience and expertise required under the circumstances. b. Management Conflicts Plaintiffs often argue that merger negotiations are tainted by management conflicts of interest, typically because of an incentive to seek lucrative golden parachute payments from the target company or to seek employment or other arrangements with the prospective buyer. To succeed on these claims, plaintiffs must demonstrate much more than that members of management had meant to favor the buyer. Plaintiffs must also show that this incentive was material to the individual, taking account of the overall context, and that the defendant took action to favor a Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

17 17 prospective buyer or otherwise to proceed with a transaction in a way that tainted the board of directors decision-making process. 81 Employment or the potential for future employment is not sufficient. Moreover, directors are entitled to use and rely on management s assistance in evaluating a transaction and negotiating a deal, taking into account any conflicts that management may have. 82 While offers of future employment may be deemed a conflict for inside directors (i.e., directors who also serve in management roles), a plaintiff must demonstrate that the offer constitutes a material interest not shared by other shareholders, and that the inside director controlled a majority of the board of directors. 83 In such cases, a shareholder would need to show that the future employment offer with a suitor would be on terms more favorable than the terms of employment with the target, that the management would be replaced if it did not support a merger, or that a competing bidder would be hostile to management. 84 Management conflicts also may arise when inside directors in management roles make a bid for the company. Mills Acquisition Co. v. Macmillan, Inc. presents an example of how matters can go awry when this type of conflict arises. 85 In Mills, the target company received competing bids from multiple potential acquirers, including a management-sponsored buyout of the company by a private equity firm that would have given management a significant ownership interest in the new company. The Delaware Supreme Court observed that the auction was clandestinely and impermissibly skewed in favor of the private equity firm because one of the insiders improperly tipped the private equity firm as to the amount of the all-cash bid by one of the competing bidders. This illicit manipulation of a board s deliberative processes by self-interested corporate fiduciaries led the Delaware Supreme Court to reject the transaction under the entire fairness standard. 86 Involvement by management in negotiating transactions or advising the board of directors about transactions does not necessarily give rise to a conflict. Indeed, courts recognize that managers can play a critical role in applying their business acumen to maximize shareholder value. In a case involving Toys R Us, the Delaware Court of Chancery rejected a shareholder s claim that the company s Revlon process was tainted by the involvement of the CEO, who served as an inside director on the board of directors. The court emphasized that to be an inside or non-independent director is not a crime, it is a status. 87 The CEO s moment-to-moment involvement was not considered problematic given that it was the CEO s duty to bring his managerial and financial savvy to bear on the auction process and given the involvement of other directors. 88 Also not considered problematic was the fact that the CEO would have gained over $60 million from the merger in light of stock and options that he held. The court observed that his interests were aligned with shareholders and that he had more incentive than almost anyone to make sure that the board did the best risk-adjusted job it could of getting the best price. 89 c. Financial Advisor Conflicts Material conflicts involving financial advisors, if not properly addressed, can infect a board of directors decision-making process and affect a court s review. Conflicting interests for financial advisors can also trigger disclosure claims, as discussed more fully below in Part III(C)(6). Financial advisors can play a critical role in assisting the board of directors to evaluate whether transactions are in the best interests of shareholders. Nonetheless conflicts can arise, in connection with either their engagement by the company for the specific transaction or their prior or ongoing representation of a party on the other side of a transaction. Investment banks can have interests that differ from the interests of shareholders. For example, fees are often contingent on completion For more ACC InfoPAKs, please visit

18 18 What s the Deal with Deal Litigation? Shareholder Merger Litigation Against Public Companies of a deal and tend to be higher when a higher transaction value is achieved. This, standing alone, is proper, but often is alleged to affect a financial advisor s support for a transaction as compared to other alternatives that might result in a much lower fee, and boards should take that fee structure into account when weighing the financial advisor s advice. 90 Advisors may also have relationships with buyers or other participants or potential participants in a transaction that might affect the advice that they give (sometimes beneficially as well as detrimentally). Open review and reasonable consideration by fully informed independent directors generally can resolve any effect of the alleged conflicts by a financial advisor. This nonetheless puts a premium on initial diligence and full disclosure by the advisors to the directors. i. Participation in Financing Participation by a target corporation s financial advisor in financing a transaction for a prospective buyer, and the resulting fee paid by the buyer to the financial advisor for such services, can sometimes taint the target board of directors process, as illustrated by the Toys R Us case discussed above. The financial advisor for Toys R Us sought permission to provide financing for the buyer of a Toys R Us subsidiary. The board of directors initially rejected the idea. 91 After a lengthy period of time in which the form of the transaction evolved, and more than two months after price and all other terms had been agreed upon and the definitive agreement signed, the board of directors agreed to allow the financial advisor to provide financing to the buyer. 92 Following scrutiny, the court concluded that the financial advisor s appearance of conflict did not have a causal influence in the board s process and thus denied a preliminary injunction. 93 Nevertheless, the court advised that financial advisors representing sellers not create the appearance that they desire buy-side work, especially when it might be that they are more likely to be selected by some buyers for that lucrative role than by others. 94 In some circumstances though, target companies may benefit from a financial advisor s provision of, or offer to provide, finance, since it may serve as a validation of the target s value, or may facilitate or expedite a transaction. A financial advisor s conflicts of interest are more likely to create problems when the board of directors has little or no knowledge of the conflict, as illustrated in In re Del Monte Foods Company Shareholder Litigation. 95 In Del Monte, the Delaware Court of Chancery preliminarily enjoined a shareholder vote and the effectiveness of several deal protection provisions on a buyout of Del Monte by a private equity group for several weeks, to allow other potential bidders to make offers in a relatively unconstrained fashion. The court found that the merger agreement occurred after collusion between Del Monte s financial advisor and the buyers. The court observed (based on the preliminary record before it) that the financial advisor: [S]ecretly and selfishly manipulated the sale process to engineer a sale transaction that would permit [it] to obtain lucrative buy-side financing fees... [and]... protected its own interests by withholding information from the Board that could have led Del Monte to retain a different bank The financial advisor did not disclose to the board of directors its explicit goal, harbored from the outset, of providing buy-side financing to the acquirer or that it had steered one private equity firm into a club bid with another private equity firm with whom the financial advisor had a strong relationship, in violation of confidentiality agreements by each of the private equity firms that prohibited discussions of a joint bid without permission from Del Monte. 97 Copyright 2011 Morrison & Foerster & Association of Corporate Counsel

19 19 Although the court found that the Del Monte board of directors was deceived by the financial advisor and that the blame appeared to lie with the financial advisor, the court nevertheless entered the injunction explaining that when corporate directors misplace their reliance even in good faith on the work of others who deceive them, the decisions made on that basis can be challenged to protect shareholders. 98 ii. Other Interests in the Transaction A financial advisor s prospective engagements may also pose a conflict of interest that taints a board of directors process. For example, when a financial advisor seeks or is promised unrelated future business by a buyer, there is a risk that the financial advisor will favor that buyer. That appearance of impropriety has raised red flags for some courts. 99 Nonetheless, a financial advisor s familiarity with many players in an industry can be helpful in advising the company, particularly with respect to interest among multiple buyers and improving the consideration offered. One key to success with respect to these issues is transparency by the financial advisors with the directors at the time any competing interests arise. Conflicts may also arise if a financial advisor has a stake in a transaction through equity ownership in the target, or in connection with debt financings previously provided. 100 For this reason, a target s board of directors should require its financial advisors to disclose any material interests in any deal so that the board of directors can evaluate those conflicts in deciding whether to retain that advisor and/or to disclose any conflicts to shareholders. 3. Allegations that the Board Used an Unfair Process Complaints frequently allege that the directors approved a transaction after an unfair process. While each complaint is unique, such allegations generally refer to one of two scenarios: 1. An alleged failure by directors to satisfy the obligations imposed by Revlon, which are discussed in Part III(A)(2) above; or 2. The use of procedures that unfairly interfere with shareholders decisions regarding a transaction. Litigation raising these type of allegations often depends on allegations that Revlon duties (or their equivalent in other state courts) arise. If they do not, the transaction, including the board s process, should be viewed deferentially pursuant to the business judgment rule. Below, we examine some of the most commonly encountered areas of focus when Revlon duties do apply. a. A Failure to Shop the Company As discussed above in Part III(A)(2), Revlon duties are flexible. The board of directors must act reasonably and pursue a process designed to obtain the best deal that is reasonably attainable, but there is no judicially prescribed checklist of sales activities. 101 Also, as discussed above, the duties involve an evaluation of more than just seeking out the best price. There is no specific obligation to shop a company before or after entering into a strategic transaction, and there are legitimate reasons related to the preservation of shareholder value for not conducting a closed auction or a broad market check before or after signing on to a strategic transaction. For more ACC InfoPAKs, please visit

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