Board games: Recent court rulings board members should heed to make winning moves

As the current financial crisis continues to expand, affecting nearly all business and governmental sectors, few industries have been left untouched. While the energy sector benefitted from unprecedented commodity price levels early last year, with oil reaching $145 a barrel in July, in late 2008 the industry also fell into the throes of the economic recession.

Assets in play

Drastically lower commodity prices, combined with the constriction of credit markets, volatile equity markets and increased financing costs have or will cause many energy players to face some difficult decisions in the upcoming months. Companies unable to fund development have been and will continue to be targeted by more financially secure competitors.

Furthermore, supermajors with excess cash may take advantage of lower asset values to acquire smaller companies or asset packages – as of December 31, 2008, Exxon Mobil, Chevron, Shell, BP, and ConocoPhillips together had over $60 billion in cash and cash equivalents. Harbingers of a potential consolidation trend may include, among others, French oil major Total SA’s January 2009 cash offer to acquire Canada’s troubled UTS Energy and BP’s late 2008 asset purchases from Chesapeake Energy.

Proceed with caution

Oil and gas players exploring strategic alternatives and potential acquisition targets should prepare to take appropriate action and to potentially do so on a compressed timeframe. Recent Delaware cases and a New York opinion involving the sale of Bear Stearns provide some guidance as to what courts may focus on when reviewing director breach of fiduciary duty claims in change of control transactions.

While there is no roadmap or a specific set of steps for directors to follow to fulfill their fiduciary duties, an examination of these cases will hopefully equip directors with some strategic moves to come out ahead in the boardroom game.

Participate

Boards should avoid delegating negotiating authority completely to executives; stay actively involved in the sale process; maintain open lines of communication with management; and act to neutralize potential management conflicts. In re: Lear Corp. Shareholders Litigation, decided in June 2007, although the court did find in favor of the directors on the plaintiffs’ breach of fiduciary duty claims, it noted that the special committee’s approach was “less than confidence-inspiring” and, among other things, directors were left out of critical discussions which prevented the committee from countering a proposed offer or providing input on negotiating strategy.

Director participation is particularly important when management may be viewed as having interests that may conflict with those of stockholders. In Lear, much of the merger negotiations were handled by Lear’s chief executive. Given the potential conflicts with other Lear stockholders due to his equity stake and retirement package, the court indicated that it would have been preferable for either the special committee chairman or the lead banker to participate in the negotiations or for the directors to provide a greater degree of guidance on negotiating strategy.

Similarly, in re: Netsmart Technologies Inc. Shareholders Litigation, decided in March 2007, where the court found a reasonable probability of a breach of the directors’ fiduciary duties, delegation of the due diligence process to management was frowned upon, notwithstanding that there was no apparent negative effect on the bidding process, because of perceived conflicts between stockholder and management interests and their potential ability to influence the process to favor certain bidders over others.

Negotiate

Boards should negotiate price and deal protection provisions and agree to terms necessary to secure the transaction. Earlier this year, in Lyondell Chemical Co. v. Ryan, the Delaware Supreme Court favorably noted when reversing the Chancery Court’s denial of summary judgment and ruling in favor of Lyondell’s directors that, among other things, the board attempted to negotiate a higher price despite the “blowout” premium offered by Basell AF, and thus approved the deal after it appeared that Lyondell had received Basell’s best offer.

In re: The Topps Company Shareholders Litigation, decided in June 2007, the court noted, in finding in some respects for the directors on the breach of fiduciary duty claims, that the board successfully upped the buyer’s offer price, and agreed to forgo a pre-signing auction process in exchange for a “go shop” period because the offer would otherwise have been withdrawn. Similarly, in Lear the record favorably indicated that the special committee negotiated better price and deal protection provisions and approved the proposed transaction only after it appeared that the offer was in danger of being pulled.

And, in In the Matter of Bear Stearns Litigation, decided in December 2008, the court noted when finding in favor of the Bear Stearns directors that the deal protection measures were necessary to secure JPMorgan’s willingness to proceed and, moreover, that the directors were able to reject or moderate some of JPMorgan’s proposed terms.

Retain advisors

Once a company embarks on course that will result in a change of control of the company it should take the earliest opportunity to retain competent financial advisors. In Lyondell the Delaware Supreme Court clarified that Revlon duties to act reasonably to secure the best price reasonably available do not arise when a company is merely “in play” but after the company has taken steps towards a change of control transaction.

Accordingly, in Lyondell, the court found that the time to begin evaluating the directors’ actions under Revlon was not when the market was put on notice of Basell’s interest in acquiring Lyondell several months before the definitive agreement was executed (when the board, in an appropriate exercise of business judgment, decided to take a “wait and see” approach), but rather when the Lyondell board began negotiating with Basell in July 2007. At that time the board promptly authorized the retention of a financial advisor shortly before the approval of the merger a week later.

Similarly, in Bear Stearns the court favorably noted that senior management met with Bear Stearns’ financial advisor promptly after the company’s liquidity problems became evident and the company began to explore its options. In that case the board approved the merger agreement less than a week later after being advised that failure to approve a deal would mean bankruptcy. When required to act on a short timeframe boards may be given leeway to act promptly under the circumstances.

In Lyondell, however, the court did note that there may be triable issues of fact as to whether the directors breached their duty of care (as opposed to loyalty).1

Seek offers

If a company is unable to conduct a meaningful market check or auction before signing definitive documents, even a limited check canvassing some likely bidders would be better than doing nothing, particularly if the market understands a company to be up for sale or if it is a well-followed large-cap company and able to consider unsolicited bids post-signing, or if it is able to successfully negotiate for a “go shop” provision to allow active solicitation of bidders post-signing.

In Lyondell the court found that while, under the circumstances, the board’s failure to take any action to confirm the Basell offer or to negotiate for a “go shop” provision did not amount to a breach of the directors’ duty of loyalty, those facts, amongst other things, could potentially amount to a breach of the duty of care.

In Netsmart, where the merger agreement did not contain a “go shop” provision and Netsmart was unlikely to be approached by unsolicited bidders post-agreement, the board was criticized for failing to undertake an exploration of interests by any strategic buyers and focusing its pre-signing sale process solely on financial buyers – the court may have felt differently if the directors had either successfully negotiated for a “go shop” provision or if the company was larger and of a type that would attract unsolicited bids post-signing.

In situations where a company is pressed for time or unable to conduct an auction or meaningful market check, it seems that it should at least, as in Topps and Lear, negotiate for a “go shop” provision to actively solicit bids post-agreement, particularly if it would be unlikely for an unsolicited competing bidder to emerge later.

Even in situations where a board may only have days to decide whether to approve a transaction, it seems advisable to engage in some type of pre-signing market check or, that failing, at least negotiate the ability to solicit bids after signing. In York Employees Retirement Plan v. Merrill Lynch & Co. Inc., involving the 2008 acquisition of financially troubled Merrill Lynch, the court found that the plaintiffs’ breach of fiduciary duty claims were colorable, notwithstanding that the transaction was not a change of control transaction subject to heightened scrutiny and the limited time the board had to act, when the company conducted a “truncated” valuation of the company and failed to conduct a pre-signing market check, and where the merger agreement did not allow for a post-signing solicitation period and included other potentially preclusive deal protection measures.

On the other hand, in Bear Stearns, also involving the sale of a distressed company, the court found that even under an enhanced standard of review the directors acted properly, although the definitive agreement did not allow the solicitation of bidders post-signing, where the company’s financial advisor in the limited time permitted contacted over a dozen potential bidders, including the most likely acquisition candidates. Although the situations are not identical by any means, taking some action beforehand to confirm an offer seems advisable, even when time is of the essence.

Evaluate options

Boards should also evaluate whether maintaining the status quo or taking other actions would be of greater value to stockholders. For example, in Topps, the special committee was formed to consider other options in addition to a sale of the company and in Bear Stearns the record indicated that the board evaluated the alternatives to approving JPMorgan’s offer (i.e., bankruptcy or liquidation where the stockholders and debtholders would receive little or nothing). Directors may reject a sale proposal if it does not believe a sale is in the best interests of the company.

However, a recent 2009 decision, Gantler v. Stephens, indicates that a board cannot reject a proposal arbitrarily. In Gantler, the Delaware Supreme Court determined that the directors’ decision to reject a sale process in favor of going private was subject to an entire fairness review, where the plaintiffs asserted that the directors rejected the sale proposal to retain their positions and maintain control and where the record indicated that the directors and officers were not disinterested in the outcome. If a board rejects a proposal it should have good reasons to do so and it should act to neutralize any actual or perceived board conflicts.

Perceptions matter

A number of the above factors courts appear to focus on when evaluating breach of fiduciary duty claims seem like little more than common sense, but not all directors consider or take some or any of these actions. Perhaps this is because directors feel that there is not sufficient time or that any delay in approving a transaction could spell disaster for the company.

On the one hand, directors could be right in certain circumstances. As recently as in Lyondell the Delaware Supreme Court made clear that there is no one blueprint for a board to follow to fulfill its fiduciary duties in change of control transactions, and courts do take facts and circumstances into account. On the other hand, courts have fairly consistently highlighted good and bad aspects of boards’ decision-making process which are difficult to ignore; even under intense time pressure a well-informed board should be able to take some or all of the above actions without unnecessarily jeopardizing the company.

And, as seen in Lyondell, which involved a 45% premium over the company’s stock price and where greater than 99% of the stockholders voted in favor of the transaction yet still drew stockholder litigation challenging the board’s actions, even a good share price needs the support of a sound board process.

According to E. Joseph Grady, senior vice president and CFO of Crimson Exploration, a public independent oil and gas company, “In my experience, there is a need for management and the board to balance the desire and need to respond rapidly to potential suitors with the need to fully vet, and value, expressions of interest with the caution and fiduciary diligence expected by stockholders. A well understood and objective review and evaluation process inside the company is the only way to strike that balance.”

Caution is a win-win

While taking some or all of the above actions may be in the best interests of a director, these actions will ultimately benefit the stockholders of the company. In ensuring that a company’s board acts reasonably under the circumstances, everyone wins.

About the Author

Patrick J. Hurley is a partner in the Houston office of law firm Akin Gump Strauss Hauer & Feld’s mergers and acquisitions practice, focusing on energy transactions.

¹In both Lyondell and Bear Stearns, claims were for monetary damages and the companies’ charter provisions contained exculpatory provisions for breaches of the duty of care. Thus, the examination in both instances was limited to whether the directors breached their duty of loyalty and not whether the duty of care was breached.