Protecting your board from shareholder lawsuits when you announce a dealFor a board of directors of a company, perhaps no decision is as important (and litigious) as the sale of the company in a change-of-control transaction. Shareholder lawsuits aimed at merger and acquisition (“M&A”) transactions (usually in the form of a putative shareholder class action or derivative suit) often allege that the directors of the acquisition target company breached their fiduciary duties in approving the transaction in question, and name the acquiring company and other defendants as aiders and abettors of the fiduciary violation. In support of their claim, the plaintiffs typically assert one, all, or a few of the following:

  • Transaction price is inadequate,
  • Directors failed to exercise due care to maximize the price being offered,
  • Transaction is coercive to shareholders because of so-called deal protection measures included in the agreements,
  • Public disclosures associated with the transaction are inadequate or misleading, and/or
  • Some or all of the directors have some form of conflict of interest.

The rationale for shareholder litigation generally stems from the idea that managerial agency costs are high, and that class actions and derivative suits are key shareholder monitoring mechanisms necessary to keep managers in line. On the other hand, representative litigation claims are often lawyer-driven, reflecting the agency costs that arise out of contingency fee suits that make the lawyer the real party in interest in these cases. In any event, the fact is that shareholder litigation in the United States has exploded in recent years. According to one study, in 2012, shareholders challenged 93 percent of M&A deals valued over $100 million and 96 percent of transactions valued over $500 million.

And while the deferential business judgment rule (i.e., the presumption that the directors’ actions were informed and taken in the good-faith belief that the actions were in the company’s best interests) generally enables directors to dispose of shareholder breach of fiduciary duty suits early in the litigation process, exercising good process and informed judgment will not necessarily prevent the company from being sued: the merger and acquisition lawsuits appear to come regardless of whether the process had any obvious problems and even if the deal seems objectively favorable for the shareholders. Where shareholder litigation cannot be avoided, the key becomes protecting the deal from a court’s scrutiny and a negative outcome.  In this regard, the board must demonstrate that it acted in an informed, deliberate manner in deciding whether to approve the deal and submit it to shareholders. Below are a few considerations that boards should keep in mind when evaluating, negotiating and agreeing to an M&A deal, and that can assist the board with its ability to demonstrate its adherence to its fiduciary duties.

  1. First and foremost, avoid conflicts of interest Where a director has a conflict of interest, (i.e., has a personal financial interest in the transaction, stands on both sides of the deal, or lacks independence), the business judgment rule is rebuttable and, as a result, courts will expose the board to higher scrutiny. Companies should inquire about potential conflicts early in the process, and should understand financial and other incentives that management or certain directors may have that could cause them to advocate for a particular outcome. In situations where directors have real or potential conflicts of interest, the board should consider appointing a special committee of independent and disinterested directors—or otherwise designate independent and disinterested directors—to evaluate the transaction on an arm’s-length basis and vigorously negotiate on behalf of the company.
  2. Don’t shortcut the process. A board must act in an informed manner and be sufficiently involved in the sales process. Well before a transaction is on the horizon, the board should consider, as part of its corporate strategy, both sides of the merger and acquisition coin (i.e., the company as a potential acquirer and as a potential target). When evaluating the terms of a deal, it is critical that boards ask hard questions and challenge the assumptions of management in an effort to ensure that all aspects have been considered. Importantly, the record should show that the board met periodically throughout the process, was appropriately advised by outside advisors and exercised informed judgment on the important decisions when it mattered.
  3. Document everything… carefully.  In addition to ensuring that an M&A’s negotiation, evaluation and agreement are the product of good process, the board must develop a good record of such process. The company’s documentation of the board’s processes (including minutes from meetings) should reflect the earnestness, diligence and care with which directors have approached their task. Importantly, directors should proceed with caution when sending private emails or personal notes, which are often subject to discovery in merger-related litigation, and can be taken out of context by plaintiff’s lawyers, undermining the appearance of good process. Each document created (including drafts), and even if marked internal or confidential, should be treated as if it will be read by a plaintiff’s lawyer.
  4. Consider, but do not bow down to, your largest shareholder. The board must make decisions for the benefit of the shareholders taken as a whole. Therefore, while the objectives of the company’s largest shareholder may be in line with the best interests of the company’s shareholders generally, in certain situations, particularly where the largest shareholder (e.g., a private equity fund) is pressing for a sale due to its own liquidity objectives, the board must keep this principal in mind. This may mean refusing to conduct a sales process or, if such a process has been commenced, refusing to accept even the highest offer on the table (because the board may have determined, after consultation with its financial advisors, that the highest offer on the table still did not adequately value the company).
  5. Retain Qualified Advisors.  In certain situations, the board may, and often needs, to rely on the professional judgment of experienced outside advisors. Where appropriate, the board should engage financial and legal advisors that are sufficiently qualified for the type of transaction posed, noting that while the company’s pre-existing advisors may “fit the bill,” under certain circumstances, the board may need to look elsewhere.

In the end, just as there is no single blueprint for selling a company, there is no one-size-fits-all approach that fulfills the necessary fiduciary duties of a director when doing so.  Further, the safe bet seems to be that shareholder litigation will ensue in many M&A transactions these days. While the above considerations cannot avoid such litigation, they can certainly further a board’s effective exercise of its fiduciary duties, and importantly, assist that board in demonstrating to a court the board’s proper exercise of fiduciary duties and that the business judgment rule should apply.