M&A Fiduciary Duties: Maximizing Shareholder Value

You owe minority investors or other shareholders special fiduciary duties when you sell your company. As I discussed in a prior post, directors, officers and others who control companies (let’s call them “control persons”), owe certain baseline fiduciary duties to shareholders.  Under Delaware law, the benchmark for corporate governance in the United States, these duties apply differently in the context of a merger or acquisition (M&A) transaction.

An understanding of M&A fiduciary duties, however, requires you to be familiar with the three standards of review that Delaware courts apply in evaluating control person decision-making. They are:

1. the business judgment rule
2. enhanced scrutiny and
3. entire fairness.

Business Judgment Rule

The business judgment rule is a set of presumptions that, in making business decisions, control persons acted (1) on an informed basis, (2) in good faith and (3) in the honest belief that the action taken was in the best interests of the company. This is the default standard in Delaware. A hallmark of the rule is that a court won’t substitute its judgment for that of a decision-maker if his or her decision can be attributed to “any rational business purpose.” In other words, when this standard of review applies, a control person’s decision is usually final and not subject to second-guessing.

There is one caveat, however. To enjoy the protection of the rule, control persons must make their decisions on an informed basis. They are required to inform themselves prior to making a decision of “all material information reasonably available to them.”

Shareholder plaintiffs frequently attempt to rebut the presumptions of the business judgment rule by trying to demonstrate some or all of the following:

• that conflicts were not disclosed
• that a majority of control persons had a conflict or were interested
• gross negligence and
• an absence of good faith (e.g., conscious disregard for relevant facts or failure to exercise reasonable oversight).

Nonetheless, when the business judgment rule applies, neither courts nor shareholders are generally permitted to challenge the wisdom of the control persons’ decisions, absent a flaw in the decision-making process.

Enhanced Scrutiny

Alternatively, control persons may be subject to enhanced (a.k.a. “intermediate”) scrutiny if they’re selling control of their company. The key features of an enhanced scrutiny test are a court’s examination of:

1. the adequacy of the decision-making process employed by the control persons, including the information on which they based their decisions, and
2. the reasonableness of the control persons’ actions in light of the circumstances that existed when the actions were taken.

Here, the control persons themselves have the burden of proving that they were adequately informed and acted reasonably. Acting reasonably, however, does not mean that decisions must have been perfect. If a control person selected one of several reasonable alternatives, a court won’t question the choice even if the judge might have decided otherwise or subsequent events cast doubt on the decision. Thus, judges won’t substitute their own judgment for that of control persons but will only determine if the decision was, on balance, within a range of reasonableness.

In the landmark case Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.,  the Delaware Supreme Court imposed an affirmative duty on control persons to seek the highest value reasonably obtainable to shareholders when a sale of a company becomes inevitable. In a subsequent case, Paramount Communications Inc. v. QVC Network Inc., the Delaware Supreme Court explained:

“The consequences of a sale of control impose special obligations on the directors of a corporation. In particular, they have the obligation of acting reasonably to seek the transaction offering the best value reasonably available to the stockholders. The courts will apply enhanced scrutiny to ensure that the directors have acted reasonably.”

These so-called Revlon duties aren’t an independent fiduciary duty but are an application of control persons’ baseline fiduciary duties. Revlon duties do not demand one particular “blueprint” for action in sales of control. There is a spectrum of acceptable behavior, judged in light of all applicable circumstances. However, control persons are burdened with obtaining more than just a fair price for shareholders. They must obtain the highest value reasonably available.

Although existing case law mandates enhanced scrutiny of control person conduct involving a sale of control, certain stock (as opposed to cash) transactions are not considered to involve a change in control for such purpose.

Entire Fairness

When control persons appear on both sides of a transaction, the presumption in favor of the business judgment rule is rebutted, and the entire fairness standard of review comes into play. It is the most onerous standard of review in Delaware, and it requires control persons to demonstrate their “utmost good faith and the most scrupulous inherent fairness of the bargain.” To that end, they must show evidence of fair dealing (i.e., that all decision-makers were kept fully informed, that the action was structured and timed appropriately and that the approvals of the decision-makers themselves were obtained properly) and fair price (i.e., that the financial terms of the transaction were within a range of fair value that a reasonable seller would reasonably accept).

There is no bright-line test to determine what level of control person self-interest triggers entire fairness scrutiny. However, generally speaking, conflicts of interest resulting in application of this standard may arise where control persons appear on both sides of a deal (such as a controlling shareholder going-private transaction) or derive a personal financial benefit that is not shared proportionately by all shareholders. In transactions that may be subject to entire fairness review, procedural safeguards may be employed to improve the odds of receiving judicial approval. These include, for example, having a special committee of disinterested, independent directors manage the transaction or obtaining approval by a majority of the minority shareholders.

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Got questions or need help with a deal? Contact Erik at erik@jassolopez.com or +1-214-601-1887.