;)
Vast corporate cash reserves combined with a volatile stock market mean that the time is ripe for many companies to consider engaging in mergers and acquisitions. M&A transactions can be used to reshape a company, whether by accelerating growth in an existing business, entering or exiting a business line, combining with another entity or even selling the company in its entirety. M&A transactions may be friendly—where the target initiates or welcomes exploration of a transaction. An M&A transaction may also begin as an unwelcome advance by a suitor, and it may turn hostile as the target tries to fend off the advance. In all cases, the board of directors plays a critical role.
Stock Illustration Source
This article discusses the nature of this role and is intended to provide an introductory overview for directors so that they can identify some of the issues that may arise in their roles as fiduciaries, whether they are on the board of the acquirer or the target. It is assumed and imperative that any board contemplating or facing a potential M&A transaction will be advised by expert counsel and other advisors as appropriate under the circumstances.
Role of the Board
Typically, the CEO and other senior executives are responsible for proposing, planning and implementing M&A transactions, under the direction of the board of directors. The board’s role is to determine whether the company should initiate a material transaction or whether a material transaction proposed by management—or by a third party—is in the best interests of the company and its shareholders such that it should be pursued. The board provides oversight of management’s efforts to oversee the M&A process and to identify and mitigate associated risks. The board also plays a role in ensuring that the company is prepared either to make or respond to a bid.
Fiduciary Duties of Directors
The corporate law of the company’s state of incorporation governs the duties of directors; this article focuses on Delaware, where the majority of S&P 500 companies are incorporated. Delaware law requires that the business and affairs of a company be managed by or under the direction of its board of directors. In practice, the board delegates responsibility for the day-to-day running of the company to management and provides oversight of management. Major decisions affecting the company—including material M&A transactions—are reserved for the board, although management typically provides relevant information and a recommendation.
Michael J. Aiello
Directors are required to fulfill fiduciary duties of care and loyalty, which cannot be delegated. The duty of care requires directors to act prudently and on an informed basis. Fulfilling the duty of care requires directors to devote sufficient time and attention to board matters and to timely consider all material information reasonably available. Directors are permitted to reasonably rely in good faith on information prepared by officers, employees, board committees and carefully selected experts (such as legal and financial advisors). The duty of loyalty requires directors to act in good faith in the best interests of the company and its shareholders, and to refrain from self-interested conduct (e.g., fraud, self-dealing, actions that serve to entrench them in office or actions motivated by self-interest, whether financial or otherwise). A director is required to disclose any conflicts of interest, to inform other directors of information of which the director is aware that may be material to a corporate decision and to keep all company information confidential.
The board’s fiduciary duties remain the same when an M&A transaction is under consideration, although its decisions and decision-making processes are more likely to be scrutinized by a court, as such transactions are often the subject of litigation. It is imperative that the board maintains records that show diligence and proper process, no matter what is on the board’s agenda. Discussions of the board’s role in M&A and specifically what steps and processes it should follow—for example, whether a special committee should be established and what its powers should be—are informed by the standards of review applied by courts when determining whether a director has fulfilled his or her fiduciary duties to act loyally with due care and in the best interests of the company. When board actions are challenged in court as a breach of fiduciary duties, the applicable standard of judicial review—and who bears the burden of proof—depends on the nature of the deal (see related story below, “Summary of Standards of Judicial Review in Cases Alleging Breach of Fiduciary Duty”). In most cases, decisions made in good faith by independent and disinterested directors on an informed basis will not be second-guessed by a court. Nevertheless, directors should remember that any process followed—and, in some cases, the decision made—will be intensively scrutinized.
Holly J. Gregory
Courts are particularly sensitive to real or potential conflicts of interest that may have tainted the board’s deliberative process—whether or not those conflicts have been disclosed and mitigated by internal processes such as information screens. Conflicts of management and financial advisors—both at a firm level and the individuals working on the deal—have recently received heightened attention by courts. The board may wish to retain its own counsel to provide advice on these issues. Independent board counsel may also be required where a special committee of the board is delegated responsibility for negotiating the deal.
Pre-Deal Preparedness
Board involvement in M&A should begin well before any transaction appears on the horizon, to ensure that the company and the board are well prepared. Preparation should focus on both sides of the M&A coin—the company as potential acquirer and as potential target (either friendly or hostile). As part of its oversight of corporate strategy, the board should ask the following questions of management on a regular basis to ensure that directors understand the business context in which issues relating to M&A may arise. The chairman of the board and/or independent lead director should ensure that the board’s agenda allows adequate time for directors to explore these questions with management. Many companies devote a special session annually to strategic issues including M&A.
- The company as potential acquirer.
- How does M&A activity fit into management’s current view of corporate strategy and why?
- What are the potential opportunities (and related risks) available for growth via acquisition? What regulatory barriers would need to be over- come, and how achievable would this be, bearing in mind the antitrust enforcement environment?
- How much cash is available to fund acquisitions, and how quickly can it be utilized? How much additional financing could be secured, from what likely sources, and in what time frame?
- What are the current M&A trends in the company’s industry and legal developments affecting the board’s fiduciary duties?
- The company as potential target.
- Are there any business units that the company is considering selling or spinning off? Would the company be more viable merging with or aligning with another company, or standing alone?
- Is the company vulnerable to an approach (for example, because of an undervalued stock price, internal dissension, business lines/assets that are particularly attractive, poor performance against peers, etc.)?
- Who are the company’s main shareholders? Do any noted activists own stock? Is management monitoring potential acquisitions of its stock (through a proxy solicitor and public filings)?
- What takeover defenses are in place at the company? Does it have a shareholder-rights plan (“poison pill”) in place or on the shelf? How are shareholders and their proxy advisors likely to react if a shareholder-rights plan is implemented, and how could implementation be managed?
- Do the company and the board have a plan in place as to how to respond to an approach?
- Does the company do a good job of explaining its strategic direction in its public documents?
- What are the current M&A trends in the company’s industry and legal developments affecting the board’s fiduciary duties?
The board should also work with management to establish ground rules on M&A activity. It should clearly delegate authority to management to engage in deals falling below a predetermined materiality threshold that are in line with the company’s strategy. These ground rules should cover, for example, expectations about the time frame and circumstances for the board to be informed of an approach that management is contemplating or that management receives. Specifically, it is advisable to develop a crystal clear understanding between the board and management about the need to inform and involve the board early and often regarding any potentially material transactions under consideration.
Evaluating a Deal
Although M&A deal ideas are typically hatched by senior executives, the boards of both the acquiring and target companies must decide whether a potential material transaction can proceed beyond an initial exploratory phase (and typically the board of a potential acquirer would need to give the green light to management to even explore a material transaction). Merger agreements require the approval of both the acquirer and target boards, as well as the target company’s shareholders and potentially the acquiring company’s shareholders if a significant amount of acquirer stock is to be issued as a deal consideration. Tender offers require board approval of the acquirer, but not the approval of the target board, since shareholders will decide whether to tender their stock; however, the target board will need to determine whether to remove a poison pill (if one exists) to allow a deal to move forward or whether to take action to resist the deal. In all cases it is essential that the board become involved at the earliest possible opportunity. On either side of an M&A transaction, the key is to ensure board involvement in an active and informed process that is not tainted by conflicts of interest (see sidebar). While there is no single blue-print for board involvement in an appropriate deal process, there are certain issues that the board should be cognizant of.
Keep it confidential. Directors are required to keep confidential all information they become aware of as directors. The fact that a company is seriously considering or has initiatied or received an approach to do an M&A deal constitutes highly sensitive information that must be kept confidential until the time is ripe for disclosure (as discussed below). The company should seriously consider whether to close the trading window during this time to reduce the risk of insider trading.
Understand the deal structure and motivations for pursuing it, including actual or potential management conflicts. The board should be constructively engaged in the development and review of senior management’s strategy to merge, buy or sell. The board should understand why management seeks to pursue a transaction, the important aspects of the transaction (strategic as well as financial) and why a particular deal structure has been chosen (e.g., merger, tender offer, asset purchase or sale). Independent advisors should be retained as appropriate to en- sure that the board has the information it needs to make decisions in the best interests of the company.
Conflicts of interest can result in serious problems, including sub-optimal deal values. They can also lead to heightened levels of scrutiny by the courts should a deal be challenged. The board should understand financial and other incentives that management or certain directors may have that could cause them to advocate for a particular outcome. For example, an interest in entrenchment, a severance payment upon a change in control, a reputational interest in leading a larger entity (“empire building”) or interest in a management buy-out of a piece of the company after the deal has closed are particularly problematic. The board should also be fully informed as to the interests of its advisors so that it can assess whether there are actual or potential conflicts that might better be avoided (see “Entire Fairness,” in sidebar below).
In situations where directors have real or potential conflicts of interest, where there is a concern that the board may be viewed as controlled by an interested party (such as a controlling shareholder or management in a buy-out situation), or where oversight of a complex transaction may be more efficiently handled by a smaller group, the board should appoint 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. The special committee should be formed as early as possible and should have a formal charter that defines the scope of its authority and the right to hire independent advisors. Counsel should advise on the scope of the committee’s charter, composition and processes to make it more likely that the actions or decisions of the special committee will receive the benefit of judicial deference.
Understand the interests of financial advisors. A company considering an M&A transaction typically retains a financial advisor to assist it in assessing the benefits and risks of pursuing the transaction. In some circumstances the board or a committee of the board may hire its own financial advisor. In either situation, the board needs to understand whether the advisor has other interests that could affect its objectivity. A financial advisor may be asked to advise on the fairness of the transaction and/or conduct a market check. The board should review the financial advisor’s mandate and the terms of the engagement letter, with a view to identifying any conflicts that may hamper the board’s ability to reasonably rely on the advice rendered. The terms of the engagement letter should spell out clearly what the role of the advisor will be, including the circumstances under which the advisor can approach potential bidders and others about a potential deal, and expectations around ongoing communication with the board as discussions with potential bidders evolve, as well as other customary provisions.
Extra care is advised when a financial advisor—the firm and/or the individual advisor working on the account—stands on both sides of the transaction (whether as an advisor or a provider of financing), holds stock in either or both of the participating companies and/or is incentivized to pursue a particular deal at the expense of others. Directors should appreciate that those outside the deal, including courts, may view the effectiveness of internal walls designed to mitigate conflicts skeptically.
Test assumptions about deal value and determine whether to undertake a market check. The board should carefully review analyses prepared by management and financial advisors about how much value a deal will add and verify key assumptions inherent in the analysis. Unfortunately, when judged with the benefit of hindsight, M&A transactions often fail to add shareholder value—whether due to overly optimistic management projections about the competitive impact or the synergies to be realized, unduly high costs or poor integration.
The board should consider whether a market check should be undertaken. Canvassing the market is prudent where real or potential conflicts are present but may not be necessary, for example, where the board is extremely knowledgeable about the company and its industry, and is not conflicted.
Select an appropriate negotiator and delineate negotiation parameters. Deal negotiations on behalf of the company should be led by an unconflicted person or team selected by the board, for example, the CEO, chairman or special committee. Independent M&A counsel should be retained to advise on deal structure, terms, etc., where appropriate (such as a transaction involving an affiliate or where management is otherwise conflicted). Other advisors such as technical experts should also be retained where appropriate. The board should provide oversight of the negotiation process and clear directions on an ongoing basis as to what the negotiator’s mandate is, including which deal terms can and cannot be accepted without further negotiation (e.g., price per share). Where a special committee is established, its mandate should be set forth in a written charter approved by the board, and should be clear as to the committee’s authority and broad enough to permit exploration of strategic alternatives beyond a particular proposed deal— as well as the ability to reject a deal.
Scrutinize transaction documents. The board should review the key terms of the transaction and ensure that they make sense from both legal and business standpoints. Terms should be checked to see how they stack up against current market practice (e.g., the size of any termination fee). Other than price, these terms should include how the transaction will be financed, closing conditions, deal protections and buyer walk-away rights. The so-called boilerplate should not be overlooked or included without critical analysis—provisions relating to forum, applicable law, entire agreement, etc., are typically not heavily negotiated but can become critical if a deal goes sour.
Apply constructive skepticism. The board bears responsibility for deciding whether a material M&A transaction can move forward. 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. Viewing the proposal through a lens of constructive skepticism may be difficult when the CEO and other members of the management team have developed strong views about a course of action, especially when a deal may be already at an advanced stage of negotiation. But such critical analysis is a key function of directors.
In a hostile situation, the target company’s board may decide to implement a poison pill (provided it has the requisite authorizations in its charter to issue blank check preferred stock), which will force the would-be acquirer to negotiate with the target company’s board or take control of the board via a proxy contest. The courts have recently reaffirmed the legitimacy of poison pills when implemented by disinterested directors acting in good faith and on an informed basis. For many companies that have dismantled defensive measures in recent years, and with the increased prevalence of hostile activity, the poison pill may be the only option a board has to stand a chance of staying independent or negotiating the optimum transaction.
Oversee corporate disclosures. Corporate communications in the M&A context should, as always, be coordinated through the senior executive team and approved as appropriate by the board. In most cases, the CEO will lead communication efforts, but in certain circumstances an independent chairman or lead director may be involved (for example, if the CEO is conflicted). Each director should be reminded that all queries about the deal are to be directed to the official communication channels, to ensure delivery of a consistent message and lower the risk of noncompliant disclosures being made.
The board should review important disclosures about the deal, such as the announcement press release, proxy statement and/or tender offer documents. M&A transactions are typically only announced when they are at an advanced stage (such as upon the signing of a merger agreement). An announcement before a deal is fully baked can wreak havoc on the company’s stock price if either or both parties back out. For this reason, many companies will not respond to market rumors, as a matter of policy.
Engage with target company shareholders and proxy advisory firms. The shareholders of the target company will decide for themselves whether to approve a deal, either through approval of a merger agreement at a shareholder meeting or by tendering shares into a tender offer. Shareholder communication by the target company board should help shareholders understand the target board’s reasons for approving or rejecting a deal. For shareholders faced with a hostile offer, an offer may seem attractive purely because it is priced above the prevailing market price, even though the offer price may be inadequate from a company valuation perspective; the target company’s board can help overcome this collective action problem by recommending that shareholders reject the offer and explaining why it believes the deal is undervalued.
The boards of the acquirer and target companies can also attempt to engage with proxy advisory firms, to ensure that the recommendations to shareholders made by such firms reflect all pertinent information.
Process, process, process. At every stage of an M&A transaction, process is critical: Does the board have the information it needs to make reasoned decisions? Has the board been diligent in its review of the deal? Are key parties disinterested, and, if not, has a special committee with appropriate powers been established? Are directors receiving advice from well- qualified, independent experts? Has the board documented its deliberations and decisions in a considered way? All of these factors should help ensure that the board’s decisions are not second-guessed by a court, even if the deal turns out to be an epic failure.
After the Deal—Integration
The board of an acquiring company continues to play a role after the deal closes, as it provides oversight of management’s efforts to implement the transaction. Post-deal integration can crystallize a host of issues, many of which may have been unforeseen at the time the deal was negotiated. Integration issues can bleed value from the combined entity and lead to the departure of key personnel. These issues may relate to, for example, cultural fit, communication habits, systems compatibility and other differences. The board should designate a member of senior management (preferably someone from the target company) to drive integration decisions and push employees to strive toward the new entity’s goals. Any layoffs, as well as other cost-saving plans, should be announced internally (and externally, where appropriate) and executed quickly.
M&A transactions are an important strategic device and stage in the corporate life-cycle. Board focus on preparation, planning and implementation is as important to success as the actual decision whether to enter into a deal. In addition, time devoted to preparation and planning can position the board to engage in M&A decisions in a manner that should lead to reasoned, informed and unconflicted decisions, and to achieve the ultimate protection of those decisions in court.
Summary of Standards of Judicial Review in Cases Alleging Breach of Fiduciary Duty
- Business judgment rule (BJR).
- Courts are hesitant to second- guess a board’s actions and, for that reason, in a claim for breach of fiduciary duty, courts generally will presume that directors acted on an informed basis and in the good-faith belief that the action taken was in the best interests of the company. This is known as the business judgment rule.
- A plaintiff can overcome this judicial presumption by showing that directors did not act on an informed basis or in good faith, or that the decision was tainted by a conflict.
- If the plaintiff succeeds in rebut- ting the business judgment rule presumption, the court will engage in a searching analysis of the board’s decision, applying the “entire fairness” test (see No. 3).
- The business judgment rule applies to most board decisions (but see Nos. 2 and 3).
- Courts are hesitant to second- guess a board’s actions and, for that reason, in a claim for breach of fiduciary duty, courts generally will presume that directors acted on an informed basis and in the good-faith belief that the action taken was in the best interests of the company. This is known as the business judgment rule.
- Enhanced scrutiny.
-
- When a board decides to approve a transaction to sell the company, or
- When a board implements defensive measures in response to an unwanted advance or perceived threat.
- While courts will defer to the business judgment of boards in most circumstances, they will apply “enhanced scrutiny” in certain circumstances, for example:
- In these circumstances, courts will scrutinize the board’s decision-making process, the information upon which the decision was based and the reasonableness of the board’s actions.
- In a change-of-control transaction, the board is required to achieve the highest value reasonably available for shareholders.
- With the adoption of defensive measures, the board must prove that it had reasonable grounds to believe that a threat to the company existed and the defensive actions taken must have been reasonable in relation to the perceived threat.
-
- Entire fairness.
- If the business judgment rule presumption is rebutted, the board will bear the burden of proving that the transaction was “entirely fair,” both as to process or “fair dealing” (looking at how the transaction was initiated, structured and negotiated) and as to “fair price” (a price that a reasonable seller would consider as within a fair-value range).
- This level of scrutiny applies where plaintiffs can make a showing that directors did not act on an informed basis, in good faith or without conflict (such that the business judgment rule presumption is rebutted).
- Note, however, that the burden of proving entire fairness will shift to the plaintiff where a transaction with affiliates (directors, management, significant share- holder) that involves inherent conflicts is approved by a special committee of independent and disinterested directors with appropriate powers and independent advisors, or a majority of minority share- holders. In limited circumstances (such as a freeze-out merger by a controlling shareholder), directors may receive the benefit of the business judgment rule presumption if a special committee is used and the transaction is approved by a majority of minority shareholders.
Basic M&A Glossary
Asset purchase or sale—where an acquirer or target buys or sells particular assets directly (such as intellectual property, plant or equipment) in a negotiated transaction.
Bear hug letter—a public or private letter sent from the acquirer to the target’s board or management proposing that the companies pursue an M&A transaction.
Blank check preferred stock—a charter provision permitting the board to issue preferred stock with preferences and other terms and conditions to be designated by the board, without shareholder approval. Required before a poison pill can be implemented.
Classified board/staggered board— where one-third of the board is up for election each year, so that it would take a hostile acquirer two annual meetings to take control of the board through the election of new directors (to remove a poison pill and/or take other action).
Exchange offer—a tender offer where the consideration offered to the target company’s shareholders is stock in the acquirer.
Fiduciary-out—a merger agreement provision that permits the directors of the target company to exercise in good faith their fiduciary duties, including talking with a third party potential bidder (which would otherwise violate a no shop/no talk provision) if the board determines that to do so would be in the best interests of the company.
Friendly—both the acquirer and target companies agree to negotiate a deal.
Hostile—the target company is not receptive to an approach from the acquirer and the acquirer may make a hostile tender offer.
Market check—a survey of the market by a financial advisor to see if higher bids for a target company may be elicited.
Matching right—a merger agreement provision that gives the potential acquirer the chance to match any superior offer received by the target.
Merger—a process whereby one company is absorbed by the other and ceases to exist. Merger structure (including choosing which company is merged out of existence) will depend on various factors, including the number and type of shareholders, tax considerations, change-of-control issues, contingent liabilities and transaction costs.
No shop/no talk—a merger agreement provision prohibiting the target company from approaching and/or talking with other potential bidders. Typically accompanied by a fiduciary-out provision.
Poison pill/shareholder-rights plan—a device that entitles shareholders of a target company (other than a hostile acquirer) to purchase newly issued target company shares at a discount if the pill is triggered by an acquisition of a certain percentage of target company shares. Triggering a poison pill would result in an unacceptable level of dilution to a hostile acquirer and forces an acquirer to negotiate with the target company’s board. If consistent with the directors’ fiduciary duties at the time, a pill can be put in place quickly by a target company’s board if necessary (without shareholder approval) and kept on the “shelf” until needed. The target company’s board can also determine whether to disable the pill.
Proxy contest/proxy fight—where a hostile bidder solicits proxies from shareholders to remove some or all of a target company’s board and the proxy contest is used in combination with a tender offer. The aim is to change the board so that takeover defenses (such as a poison pill) can be removed and the deal can close.
Reverse termination fee—a provision requiring the potential acquirer to pay a fee to the target if the acquirer cannot or does not complete the deal. Common in private equity deals.
Special committee—comprised of independent and disinterested directors who negotiate with potential acquirers and determine whether or not to approve a deal. Typically established in transactions involving an affiliate (such as a member of management) or other conflict of interest.
Squeeze-out merger/freeze-out merger/ short-form merger—a merger of a target company into an acquirer where the acquirer already owns at least 90 percent of the target’s common stock. The target company’s shareholders are not required to approve the deal. Typically used after an acquirer has reached the 90 percent threshold via a tender offer.
Tender offer—where the acquirer offers to purchase target company shares directly from the target’s shareholders.
Termination fee/break fee/break-up fee—a provision requiring the target to pay a fee to the potential acquirer if the target backs out of the deal.
Michael J. Aiello is chairman of Weil, Gotshal & Mange LLP’s Corporate Department and co-head of the firm’s New York Private Equity and Mergers & Acquisitions practices. Holly J. Gregory is a partner at Weil where she specializes in advising companies and boards on corporate governance matters. Rebecca C. Grapsas and Adé K. Heyliger assisted in preparing this article.
There is very good advice here, and no doubt that the role of the Board is critical. But the importance of the post deal integration cannot be overstated. I have personal experience of two acquisitions where a poorly managed integration phase led to mass disillusion and an exodus of key staff. The value of an acquisition can disappear very rapidly if the integration phase is not planned in detail in advance.
Could not agree more, Peter.