Delaware Court Provides Guidance on Acceptable Deal Protection Mechanisms and Scope of Third Party Aiding and Abetting Liability in a Sale-of-Control Situation
On November 25, 2014, the Delaware Court of Chancery issued a decision in In Re Comverge, Inc. Shareholders Litigation, which: (1) dismissed claims that the Comverge board of directors conducted a flawed sales process and approved an inadequate merger price in connection with the directors’ approval of a sale of the company to H.I.G. Capital LLC; (2) permitted fiduciary duty claims against the directors to proceed based on allegations related to the deal protection mechanisms in the merger agreement, including termination fees potentially payable to HIG of up to 13% of the equity value of the transaction; and (3) dismissed a claim against HIG for aiding and abetting the board’s breach of fiduciary duty.
The case provides important guidance to directors and their advisors in discharging fiduciary duties in a situation where Revlon applies and in negotiating acceptable deal protection mechanisms. The decision also is the latest in a series of recent opinions addressing and defining the scope of third party aiding and abetting liability.
The case involved the acquisition by HIG of Comverge at $1.75 per share, representing an equity value of approximately $48 million. During the period the merger discussions took place, Comverge was confronting a steeply declining share price, reporting annual net losses, and facing a liquidity crunch. The transaction was structured as a two-step acquisition, whereby HIG acquired shares in a public tender offer, and then executed a back-end merger to complete the takeover. Comverge also granted HIG a “top-up option” that could enable the second step to be completed in a short-form merger. Approximately 65% of Comverge’s outstanding shares were tendered, after which HIG exercised its top-up option and the merger became effective on May 15, 2012.
The merger agreement also required HIG to make a $12 million bridge loan to Comverge, and the associated notes were convertible into 8,571,428 shares of Comverge common stock at $1.40 per share. As part of the agreement, Comverge had a 30-day “go-shop” period (with the possibility of a 10-day extension) to seek a superior offer, and if it obtained one it was obligated to pay termination fees to HIG of $1.206 million during or $1.93 million following the go-shop period, and to reimburse HIG up to $1.5 million in expenses. HIG also agreed to forebear exercising rights under $15 million in convertible notes acquired from a third-party lender, PFG, in the course of merger negotiations, pursuant to which HIG obtained the right to block any alternative acquisition proposal.
Significant stock ownership by directors is a powerful argument against allegations that directors did not intend to maximize shareholder value. Given that the transaction involved a sale of control, the Court assessed the plaintiffs’ sales process claims under Revlon, which in turn involved an assessment of whether: (i) the directors subjectively were motivated to maximize shareholder value; and (ii) directors’ decision-making process, including the information they considered, objectively was adequate and reasonable.
In analyzing subjective intent, the Court found that the Directors were independent and disinterested in the transaction. Only one of ten directors was a company employee and he did not participate in the final vote on the merger. Importantly, the directors collectively owned over 900,000 shares of Comverge stock, and as substantial stockholders, they “personally were invested” in obtaining the highest price possible for the stock such that their motivations were aligned with other Comverge stockholders. This fact undermined any suggestion of bad faith by the directors and is consistent with the principle articulated recently in a different context in In re: Crimson Exploration Inc. Stockholder Litigation. There, in rejecting allegations that a supposed controlling stockholder was conflicted in connection with a merger transaction, Vice Chancellor Parsons found, even at the pleading stage, that there is a presumption that stockholders are incentivized to seek the highest price for their shares. To overcome that presumption, plaintiffs must allege “specific facts or theories persuasive enough to render it reasonable” to conclude that the supposed controller acted contrary to its “self-interested incentives as stockholders to maximize value.”
In addressing whether directors acted reasonably courts will consider all surrounding circumstances, including external conditions affecting the company. The Court made short work of most of plaintiff’s arguments for finding the directors’ conduct objectively unreasonable. Plaintiffs challenged the Board’s decision to grant HIG a period of negotiating exclusivity, but the Court recognized that the board initially pushed back against HIG’s demands for exclusivity, and negotiated a reduced exclusivity period of 20 days, compared to the original 30 days that HIG requested. While acknowledging the “unfortunate” timing of the exclusivity agreement, given that two days into the period another bidder emerged and expressed interest in an acquisition at $4.00-6.00 per share, the Court stated that “Revlon requires reasonable decisions, not perfect ones.”
Plaintiffs also challenged the board’s decision, after consulting with advisors, not to sue HIG for breaching the standstill provisions that were contained in the non-disclosure agreement it entered into in connection with merger discussions. Such a lawsuit would have been based on HIG purchasing PFG note and the associated blocking right. The Court found that the board’s decision not to sue, and instead to negotiate for an effective go-shop provision, while a “debatable” tactical decision, was reasonable. In so ruling, the Court took into account that the board made its decision in the midst of strategic negotiations with HIG; there were “non-frivolous” arguments advanced by HIG for finding that it did not violate the NDA when it purchased the PFG note such that the outcome of litigation was highly uncertain; suing would have caused HIG, the only firm bidder, to terminate merger discussions; and the company then would have faced a possibility of bankruptcy given its liquidity issues at the time.
On the other hand, “perfect storm” arguments only go so far. The Court found that the board’s decision to sell at $1.75 per share pled a claim for breach of the directors’ duty of care obligations. The Court observed that the deal represented a negative premium (referred to by Comverge’s largest stockholder as a “takeunder”), and the board had rejected as too low an offer of $2.25/share offer from HIG (28% higher than the merger value) a little over a month earlier. Importantly, at the motion to dismiss stage, the Court rejected as insufficient to warrant dismissal the directors’ argument that the circumstances presented a “perfect storm” and the board got the best deal it could in light of the liquidity and other issues confronting the company. In addition to the considerations noted above, the Court stated that the “perfect storm” was caused at least in part by Comverge itself, which permitted HIG to exploit a “weakness” in that it was able to acquire the PFG note and with it the right to block alternative transactions.
Nonetheless, the Court dismissed the due care claims against the directors in light of Comverge’s Section 102(b)(7) charter provision, pursuant to which directors are protected from personal liability for monetary damages for breaches of due care. Nor did the complaint plead a breach of loyalty obligations, which would not be covered by the exculpation provision. The Court stated that to plead a loyalty breach in the context of a sale of control, the complaint must plead that the directors intentionally disregarded their duties by “‘utterly failing to attempt to obtain the best sale price.’” The directors’ conduct could not “conceivably rise to [that] level,” according to the Court, where the board formed a disinterested and independent transaction committee, hired financial and legal advisors, held numerous meetings, widely canvassed the market of potential transaction partners, and considered financing strategies as alternatives to selling the company. The Court also considered that the board obtained a fairness opinion, negotiated for a price increase from $1.50/share to $1.75 (HIG renewed its interest at $1.50/share after the board had rejected its $2.25/share offer several weeks earlier) and obtained a go-shop period in the merger agreement.
Passive acceptance of potentially preclusive deal protection mechanisms may rise to the level of stating a breach of loyalty claim in a sale of control situation. The Court summarily rejected plaintiff’s complaints about two deal protection mechanisms contained in the merger agreement: (i) the length of the go-shop period (which the Court deemed “typical”), and (ii) the directors’ agreement to grant HIG a top-up option (finding that the Delaware legislature had essentially approved this transaction structure in 2013 when it adopted Delaware General Corporation Law Section 215(h)). However, the Court found that the termination fee structure in the merger agreement could be preclusive of other offers. Here, Comverge agreed to a two-tier termination fee in which it would pay HIG $1.206 million if it entered into a superior transaction during the go-shop period and $1.93 million after the go-shop period expired. Comverge also agreed to reimburse HIG for expenses up to $1.5 million under either scenario. Those fees represented 5.55% to 7% of the deal’s equity value, where even 5.55% “tests the limits of what this court has found to be within a reasonable range for termination fees.” If the parties’ bridge financing agreement were considered (an issue the Court did not definitively resolve), pursuant to which Comverge allegedly would have to pay HIG an additional $3 million if a superior transaction emerged upon conversion of the notes, the termination payment amounted to 11.6% to 13.1% of the equity value of the transaction. The Court determined that allegations regarding such termination fees stated a due care claim because they could have had an unreasonably preclusive effect on potential bidders who might have topped HIG’s offer, particularly “in the context of a deal with a negative premium to market.” The allegations also pled a loyalty breach, which was sufficient to overcome the Section 102(b)(7) exculpation provision, because if the convertible notes HIG received as part of the bridge financing arrangement are taken into account, the board’s “passive acceptance of those terms without any pushback” conceivably was “so far” beyond the bounds of reasonable business judgment as to be “inexplicable” except as bad faith.
Stockholder understanding of merger agreement provisions may be relevant to whether deal protection mechanisms have a preclusive effect. In addressing whether the convertible notes that HIG acquired in connection with providing bridge financing should be considered “in tandem” with the termination fee and expense reimbursement provisions, the Court took into account the understanding of Comverge’s largest stockholder. In a publicly filed letter, the stockholder characterized the convertible notes as a “second break-up fee designed to have a chilling effect.” The Court factored in the stockholder’s understanding in concluding that the convertible notes may have been viewed by potential bidders as additional termination fees.
The decision provides additional guidance on when a third party may be liable for aiding and abetting a board’s alleged breach of fiduciary duties. The Court dismissed the aiding and abetting claim against HIG and in doing so distinguished certain other recent decisions finding liability or refusing to dismiss aiding and abetting claims. The Court recognized that in order for a third party to “knowingly participate” in a fiduciary’s breach the third party must do more than engage in arm’s length, hard-fought negotiations. Rather, the third party must exploit a position of trust or conflicts of interest on the part of directors, or otherwise knowingly act so as to participate in a board’s breach of fiduciary duties. Here, there were no such allegations. And, the Court rejected allegations that HIG, in supposedly breaching the NDA when it acquired the PFG note and then using the associated blocking rights to “extract a low-ball sale” price, went beyond hard bargaining. The Court found that, even “while arguably suspect,” HIG’s acquisition of the PFG note was consistent with a plausible construction of the NDA, which in turn “severely undermine[d]” any allegation of bad faith on the part of HIG.
The Delaware Chancery Court has issued a number of recent decisions that, taken together, provide guidance on the developing contours of aiding and abetting liability. In In re Rural/Metro Corp. Stockholders Litigation, for example, Vice Chancellor Laster found a financial advisor to a seller’s board liable for aiding and abetting the directors’ breach of fiduciary duties due to the advisors’ conflict of interests and resulting failure to act in the best interests of the client.
In another recent decision, Vice Chancellor Laster again addressed an aiding and abetting claim, this time against a company’s lender. The lender, at the request of the company-borrower, agreed to amend the lending agreement to include a “dead hand proxy put” following threats of a proxy contest. (A dead hand proxy put is a provision in a corporate debt agreement, pursuant to which there is an event of default and the corporate debt is accelerated if, typically, within a certain time period a majority of the company’s directors are not “continuing directors,” i.e., directors who were on the board at the time the debt agreement was signed or who were appointed by such persons. The “dead hand” aspect means that the borrower’s board cannot waive it. Delaware decisions discussing these types of provisions recognize their potential to deter third party acquisition offers and to coerce stockholders to vote for the incumbent board.) In a bench ruling in the case, Pontiac General Employees Retirement System v. Healthways, Inc., the court allowed plaintiffs’ aiding and abetting claim against the lender to survive a motion to dismiss, noting that while a contractual counter-party can “negotiate for the best deal that [it] can get,” a party in the lender’s position cannot knowingly “propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts on the other side of the negotiating table face.”
These decisions, particularly Healthways, suggest an increased willingness on the part of the Delaware Court of Chancery to hold third parties responsible for “knowingly participating” in a breach of fiduciary duties, although clearly more than hard bargaining of the type engaged in by HIG is required.
A copy of the decision is available here.