The Board's Role in a Sale to a PE Firm

Over the last several years, private-equity funds have fueled deal-making activity that only recently abated due to the dislocation in the credit markets. This temporary lull provides an appropriate time to review the lessons from several recent decisions of the Delaware Court of Chancery, the nation’s preeminent business court, concerning the litigation that inevitably follows the announcement of a “going-private” transaction.

As a starting point, these decisions teach that private-equity deals, like other sale transactions, require that directors exercise informed business judgment in taking reasonable steps to secure the highest price reasonably available for their shareholders. Nothing about a sale to a private- equity buyer has altered this fundamental precept.

However, these decisions focus on the incentives senior management may have to conclude a sale to a private-equity fund at the exclusion of so-called “strategic” buyers. As financial and not strategic buyers, private-equity funds are likely to maintain existing management after the deal closes, sometimes with substantial cash and equity compensation. A going-private transaction may also give executives an opportunity to trigger existing change-in-control provisions to bypass the usual restrictions on trading in company stock and cash out their own equity. Of course, the premium typically paid by an acquirer sweetens the deal. Delaware courts have found that these potentially significant benefits may tempt senior executives to favor sales to private- equity funds. Because of this potential for conflict, directors should take an active role in any sale process, including one to a private-equity firm.

For example, in a recent decision involving the sale of a technology company to two private- equity firms, the Court of Chancery was troubled that:

• The board made no effort to canvass strategic buyers and instead only considered private-equity buyers.

• The board’s special committee had no involvement in the diligence process and gave management substantial access to their deliberations.

• Management discussed its future compensation with the potential buyer while negotiations were ongoing.

In the end, the Court found that by failing to consider strategic buyers, the board had no reasonable basis to conclude that the deal was in the best interest of shareholders.

The board can take steps to manage these potential conflicts at the outset of a sale process. The board should ask members of senior management if they are prepared to preclude themselves from serving as officers of the surviving company (other than to assist in any transition) and from acquiring any economic interest in the acquisition vehicle. Those officers who are prepared to preclude themselves can be permitted to participate in the sale process. In contrast, those officers who are not so prepared should be required to disclose to the board all communications that they have had with the potential buyer. Following full disclosure, the board can determine what role, if any, such officers should play in the transaction and how that role should be managed.

Other measures the board can take to protect the integrity of any sale process include:

• Create a committee of disinterested directors to run and manage the process.
  

• Retain financial and legal advisers who have no material connection to management.

• Refrain from discussing management participation in the new entity until price and other material terms have been agreed upon.

In the end, going-private transactions with private-equity funds often present the best opportunity for shareholders to receive an immediate and substantial premium for their shares. Directors must be cognizant, however, of the potential for conflict between the interests of management and the interests of shareholders.

David Hennes is a litigation partner at Fried, Frank, Harris, Shriver & Jacobson LLP’s New York office.