A board of directors faced with a conflict transaction--such as a transaction with a controlling stockholder or, in many cases, an acquisition by a financial buyer where management will be retained and will receive equity in the post-acquisition entity--will usually form an independent committee of directors to consider the transaction. The required attributes of an independent committee process are by now fairly clear under Delaware law. However, recent cases have pointed out a few remaining uncertainties in the Delaware law governing committees, particularly as regards the scope of authority that must be given to a committee and the legal standards that a reviewing court will apply in assessing a committee process. Perhaps more importantly from a practitioner's standpoint, recent cases also highlight certain recurring fact patterns that have undermined committee processes. This article briefly reviews the legal uncertainties, and then turns to these recurring facts patterns and suggests ways that counsel could deal with them.
Settled Law and Remaining Uncertainties
Under Delaware law (as generally outlined in In re So. Peru Copper Corp. S'holder Derivative Litig., 2011 WL 6440761 (Del. Ch. 2011)), a transaction with a controlling stockholder, or a transaction in which a majority of the board otherwise has a conflict, will be reviewed under the entire fairness standard. This means that the defendants will bear the burden of proving that the transaction was entirely fair, both in terms of "fair process" and "fair price." If the defendants cannot satisfy this standard, they may be personally liable for damages.
However, the proper use of an independent committee can provide significant protection for directors by changing how these legal standards are applied, either by changing the standard of review, shifting the burden of proof, or providing evidence of fairness. In a transaction with a controlling stockholder, use of an independent committee can shift the burden of proof under the entire fairness standard back to the plaintiff. In a transaction not involving a controlling stockholder, it can change the standard of review from the entire fairness standard to the business judgment rule. In either case, whether or not there is a change in the standard of review or burden shift, the committee process can itself be important evidence of fairness.
Within this relatively settled framework, recent cases have pointed out three open questions.
Scope of Authority
The first question relates to the scope of authority that must be granted to or exercised by the committee. It is not clear that a committee will result in the benefits discussed above, particularly the benefits relating to burden of proof and standard of review, unless the committee is granted broad authority. This could include not only the standard "power to say no" to any given transaction, and the power to retain independent advisors, but also the power to consider alternative transactions (even in response to an offer from a controlling stockholder who could potentially veto other deals) and to take defensive measures to protect stockholders. In re CNX Gas Corp. Shareholders Litigation, 2010 WL 2705147, *10 (Del. Ch. 2010); In re So. Peru Copper Corp. S'holder Derivative Litig., 2011 WL 6440761, *23 (Del. Ch. 2011).
Standard of Review
The second open question relates to standard of review in a transaction with a controlling stockholder. The Chancery Court has suggested that the use of an independent committee, if combined with a "majority of the minority" stockholder vote, should result in the full protection of the business judgment rule, rather than simply a shift in the burden of proof under the entire fairness standard. At the same time, the Chancery Court has laid down stringent requirements for committees in this context, including, generally, that the committee's authority match that of an independent board as much as possible. In re CNX Gas Corp. Shareholders Litigation, 2010 WL 2705147 (Del. Ch. 2010). The Delaware Supreme Court has yet to rule whether it will adopt the Chancery Court's suggested approach as the law of Delaware.
Shift in Burden of Proof
The third open question relates to when a court will determine whether a committee process has the effect of shifting the burden of proof in a control stockholder transaction. Chancellor Strine recently concluded in In re Southern Peru Copper Corp. S'holder Derivative Litig., 2011 WL 6440761, *23 (Del. Ch. 2011), that the precedents dictate that this cannot be determined until after the trial court has reviewed the factual record to decide whether the committee functioned properly. He also candidly noted that if a court cannot determine who bears the burden of proof until after reviewing all the facts, it calls into question the relevance of a "burden shift" as a practical matter.
Recurring Fact Patterns to Address
Even in the midst of some uncertainty concerning the legal rules applicable to committees, lawyers who advise committees can help ensure the maximum effectiveness of a committee process by being alert to certain recurring fact patterns that have troubled the courts in recent cases.
Scope of Authority Granted to the Committee
The courts have clearly signaled that because a primary purpose of an independent committee process is to replicate the process that an independent board would go through in a transaction with a third party, the committee should have powers that are generally comparable to the powers of a board in such a situation. The courts have focused recently on whether a committee must be given the power to consider alternatives, including in response to a proposal made by a controlling stockholder. Delaware law is fairly settled that if a controlling stockholder has stated that it will vote its shares against other transactions, then a board generally does not have a duty to pursue the "futile act" of shopping for alternative deals. It might therefore be argued that a committee need not be empowered to consider alternatives if the controlling stockholder has made such a "veto statement." On the other hand, arguably the decision whether or not to believe the veto statement, and what to do in response to it, is a decision that should be left to the committee. A decision "not to shop" may be perfectly defensible if made by the independent committee, but subject to attack if foreordained by the board as a whole. An important role for committee counsel in this context is to make sure the committee understands the scope of the authority granted to it, and to discuss with the committee whether it could be advisable to seek to expand that authority.
Committee Member Conflicts
A court may not respect a committee process if it is not fully convinced that the committee members are in fact independent in relation to any conflicted parties and the transaction in question. Recent cases have focused on the need for liquidity as a potential conflict. In the Southern Peru case, for example, a committee was established to consider a transaction proposed by a majority stockholder. One committee member was affiliated with another large stockholder that wanted to liquidate its stake, but could not do so unless its stock was registered--a decision which the court found was controlled by the majority stockholder (through its control of a majority of the board). The court concluded that this "liquidity conflict," although different from a "classic self-dealing interest," nonetheless called into question the independence of the committee member.
Another example of a liquidity conflict arose in the Chancery Court's recent decision in N.J. Carpenters Pension Fund v. infoGROUP, Inc., 2011 WL 482588, *10 (Del. Ch. 2011). There it was alleged that the CEO had pushed for a sale of the company because he needed liquidity to fund another venture of his own and to cover certain personal liabilities. The company was being sold to an unrelated third party and therefore the sale itself did not raise conflict issues. However, the court found that the CEO's liquidity needs compromised his independence, and in turn infected the sale process as a whole given his central role in negotiating the deal and leading the board.
An important role for counsel can be to flush out any actual or potential conflicts of interest at the outset of a committee process. This might be done by interviewing the committee members or providing them with a detailed questionnaire. If a conflict or potential conflict is discovered, it is not necessarily disqualifying for the committee member. It may be crucial, however, that the matter be disclosed to and discussed by the committee as a whole, so that the record can reflect the committee's knowledge of the matter and its collective judgment whether to take any action. This point was highlighted in another recent decision of the Delaware Chancery Court, In re El Paso Corp. S'holder Litig., 2012 WL 653845, *8 (Del. Ch. 2012), where both the CEO and the board's investment banker were found to have had conflicts of interest that were not disclosed to the board. The court stated that "[w]hen anyone conceals his self-interest . . . it is far harder to credit that person's assertion that self-interest did not influence his actions." Committee counsel can often play an important role in flushing out such conflicts at the outset, rather than waiting for them to surface in litigation, when they are likely to cause far more damage.
Committee Control of Management
Another recurring "bad fact pattern" is where management rather than the committee appears to be leading the process, but management has a conflict of interest. Such a conflict often arises in connection with a sale of the company to a financial buyer which plans to retain management and provide management with new equity (i.e., a rollover). The Delaware courts have emphasized repeatedly that in this context, it is important for the record to reflect that the committee actively directed the process rather than ceding control to management. In litigation challenging the buyout of J. Crew, for example, (In re J. Crew Group, Inc. Shareholders Litigation, C.A. No. 6043 at 66 (Del. Ch. Dec. 14, 2011)), the court commended the committee for implementing management guidelines that restricted management's ability to discuss retention or equity participation with bidders, unless authorized by the committee. Damage had already been done, however, because the CEO had brought in the winning bidder, and discussed his own retention and rollover package with that bidder, before the board as a whole was made aware of the potential sale and was able to establish the independent committee. Chancellor Strine criticized boards in general for not having in place policies to prevent CEOs from front-running sale processes in this manner:
I really don't understand why it is not expected of all public company boards that they have protocols in place to deal with the [not] unusual circumstance of whether the CEO decides that the best strategic option for the company might be a sale. It is, in my view, outrageous for a board to be the last to know when the CEO changes the fundamental strategic direction in his own mind . . .
I believe that there are deals tainted by CEOs messing around early, boards not having policies in place. It's inexcusable for companies to be doing this. I don't get why all boards don't have policies to say, when the CEO changes in his own mind that it's a viable option [to sell the company], the board hears first. The company's advisors belong to the company. You don't talk to employees. You don't share confidential information. You don't make promises to work for anybody else, or anything like that, without talking to us. And there are many defense lawyers and people who advise boards in the room, and it's really not excusable [that they fail to implement such policies].
In re J. Crew Group, Inc. Shareholders Litigation, C.A. No. 6043 at 66, 69-70 (Del.Ch. Dec. 14, 2011) (Transcript).
Committees should expect similar criticism if they do not move forcefully to control management's role in a sale process in which management may have a conflict of interest. This does not mean that it is necessarily required to exclude management from the process, and it will typically be neither feasible nor advisable to do so. But the committee and its counsel should develop a clear record that they actively dealt with the issue and implemented rules to mitigate the potential for any management conflict to affect the process to the detriment of stockholders as a whole.
Financial Advisor Conflicts
An independent board or committee process may also be undermined by conflicts of interest on the part of the directors' financial advisor. The Delaware Chancery Court has repeatedly emphasized the importance of vetting and disclosing "banker conflicts," and the serious risk that such conflicts may pose to a sale process:
Because of the central role played by investment banks in the evaluation, exploration, selection, and implementation of strategic alternatives, this Court has required full disclosure of investment banker compensation and potential conflicts. This Court has not stopped at disclosure, but rather has examined banker conflicts closely to determine whether they tainted the directors' process.
In re Del Monte Foods Company Shareholders Litigation , 25 A.3d 813, 831-832 (Del. Ch. 2011) (citations omitted).
In addition, as noted in the El Paso case, the concealment of such conflicts magnifies the substantive problem. Thus in the Del Monte case, the court enjoined a merger primarily because of the undisclosed actions of a conflicted banker, notwithstanding that the board of directors itself was independent and the sale was to a third party. The banker's actions included arranging to provide financing to the buyer before a final deal price was struck.
The conflict created when a target financial advisor also provides buy-side debt financing--so-called stapled financing--was again considered by the court in the El Paso case. There, interestingly, Chancellor Strine took care at the hearing to note that such financing was not necessarily a problem if an independent committee controlled the process and could show a benefit to the company, such as luring more bidders or a potentially higher price.
Conclusion
In summary, regardless of where a conflict originates or what course of action is chosen, the key issue in a committee process will often be whether the record reflects that the committee was proactive, in control and made an informed judgment on the matter, or whether the committee instead appeared to be a passive victim of the conflicted party (whether a banker, management, a conflicted committee colleague, the board as a whole, or a controlling stockholder).