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ABA Section of Business Law


Volume 12, Number 6 - July/August 2003

Does M&A mean Manage & Adjust?
Beware new ground rules, new hazards
    By Brett Goldblatt and Sheryl L. Cefali

Even small, simple deals now require board scrutiny and thorough documentation. Relying on outside counsel is often not enough.

House counsel who haven't been involved in any mergers, acquisitions or divestitures in recent years may be in for some unpleasant surprises. The ground rules governing M&A activity have changed drastically since the mid- 1990s, and companies that aren't aware of the new environment are inviting trouble — intensified SEC scrutiny that can delay or even kill deals, and lawsuits accusing directors of shirking their fiduciary duties to shareholders.

To this, house counsel may shrug and say, "I'm not concerned about that. We have outside counsel to handle such matters."

That attitude may provide a false sense of security. As advisers in many M&A transactions, the authors have seen a number of situations in which companies' outside counsel — apparently unaware of the SEC's new ground rules — did a poor job of leading clients through the process that must be followed in M&A transactions today. This has resulted in significantly prolonged filing periods with the SEC and increased exposure to shareholder lawsuits. The purpose of this article is to inform house counsel about what this process involves, who should be doing what, and when they should be doing it.

It is important that house counsel be involved from the moment the board of directors contemplates a significant M&A transaction. Outside counsel have specific expertise, which house counsel can take advantage of, but there is a critical role to be filled by house counsel. The corporate ship needs a navigator who understands the company's corporate culture and relationships, and can guide the company and its board through the complicated new regulatory environment.

There are three primary functions that house counsel need to perform in M&A transactions.

First, house counsel must educate the company's directors as to their overriding fiduciary duties to the company's shareholders, particularly in light of the increased scrutiny afforded board actions, as seen in the recent enactment of Sarbanes-Oxley by Congress. Second, house counsel should understand the significantly heightened level of disclosure and renewed focus on the board's deliberation process by the SEC. Third, house counsel needs to have a well thought-out game plan in place to make sure that the process undertaken by the board of directors will satisfy the board's fiduciary duties owed to shareholders and survive the SEC's enhanced scrutiny.

With the enactment of Sarbanes-Oxley, house counsel more than ever are key players in providing guidance to senior management and the board of directors on how best to meet their fiduciary responsibilities. Board members and executive management must subjugate their own interests to their obligations to act in the best interest of shareholders. In an M&A transaction, areas to be particularly aware of are conflicts of interest and independence.

In light of the scandals at Enron, Andersen and others, it's not surprising that the SEC and the courts are stressing the importance of board independence — that in M&A deals, directors have a fiduciary responsibility to public shareholders at large, not to officers, directors or any single large shareholder. E. Norman Veasey, chief justice of the Delaware Supreme Court, said it best in a roundtable discussion on executive compensation that appears in the January 2003 issues of the Harvard Business Review: "[W]e didn't fall off of the turnip truck, you know. We can tell whether somebody is acting independently or not. . . . Directors who are supposed to be independent should have the guts to be a pain in the neck and act independently."

If there is any hint of a conflict of interest in a proposed transaction, a special committee made up of independent directors must be formed. The committee must consist solely of directors with no interest in the M&A transaction (and, oftentimes, unaffiliated with management) and is formed to make key decisions in conflict-of-interest situations, regardless of whether management agrees with them. As the Delaware Chancery Court explained in In re TWA Inc. Shareholders Litig., in an M&A transaction where majority shareholders have interests on both sides of the transaction, the special committee's purpose is to emulate the arm's length process and "aggressively seek to promote and protect minority interests."

To be effective, a special committee must have independent financial and legal advice: It should be provided with all relevant information necessary to make an informed business decision. It must possess enough bargaining power to simulate arm's-length negotiations.

Even before a special committee retains its own legal counsel, house counsel and other counsel brought in for the transaction should thoroughly explain to committee members what their role will be, emphasizing the necessity of establishing and maintaining a posture of independence. Then it's up to the committee's own counsel to explain how the committee is to perform its duties.

At this point one might ask, what makes a director truly independent? Obviously, directors or advisers who have a material and conflicting interest in the matter will not be regarded as independent. At the other end of the spectrum, directors and advisers with no other relationship to the parties or the transaction involved will certainly be considered independent.

But what may be said about that wide gray area between these two extremes? The courts have held that no "direct nexus" has to exist between the director and the transaction for a director to cease to be independent; indirect interests may be enough to disqualify a director or adviser. The same holds true for a special committee's advisers. Generally, however, the conflicting interest must be material enough to interfere with the director's or adviser's independent judgment in representing shareholders before it will present a meaningful conflict and disqualify a person from serving on or advising a special committee.

Even if there is not a conflict of interest for directors, they still must act independently. Not long ago, board meetings on proposed transactions were held only to rubber stamp decisions already made by the president or the CEO. Today, though, appearances are almost as important as substance. Directors should be told that they can't simply say they approved a transaction because management likes it and the financial adviser said it was fair. The board must say, "We studied this deal, we discussed it, and we think it's fair," and explain how it came to that conclusion. Now, more than ever, directors are expected to act independently, in the best interest of shareholders, and fulfill their obligation to be fully informed of all material facts before making business judgments.

In the public company context, the SEC has certain after-the- fact expectations about what course the directors should have followed in recommending an M&A transaction to its shareholders. We say "after-the-fact" because these expectations are embedded in the SEC's rules for what must be contained in the proxy statement distributed to shareholders and the proxy is not put together until after the board has completed its deliberation process. Consequently, it is important to understand these requirements early on.

A good rule of thumb is that the SEC now wants as much detail as had previously been required only in tender offers or going-private transactions. When a company puts together its proxy for shareholders, the SEC generally requires that it disclose:

  • The background and events leading up to the transaction;
  • The purpose of the transaction;
  • Alternative transactions considered, and the reasons for rejecting them;
  • A discussion of the transaction's merits;
  • A statement as to whether the company reasonably believes that the transaction is fair or unfair to its shareholders; and
  • A detailed discussion of the material factors that led the board of directors to the conclusion that the transaction is fair or unfair.
To comply with the increased disclosure requirements of the SEC, the company's management — and, ultimately, the board of directors — will have to explain the background and merits of the transaction in detail in the proxy statement. The company must effectively highlight the deliberation and decision-making process and independence concerns to a significantly greater extent than before. It should be apparent that some planning has to be done before the board meets — to make sure all of these points will be covered. At the end of the process, the board must be able to support its conclusion that the proposed transaction was fair and in the best interest of the shareholders.

So, what should the board be doing and how can house counsel help to manage the process?

The first step for house counsel in managing the process is to analyze, along with outside counsel brought into the transaction, the likely expectations of the SEC viewing the deliberation process and proxy disclosure in the context of the proposed transaction. House counsel will then be able to develop a game plan for the company and its board to follow.

That game plan should include a preliminary schedule of board meetings, agenda items to discuss in upcoming board meetings, what to expect from the financial adviser (including presentations to the board of directors), and the importance of timing and full disclosure.

The question most often asked by house counsel is "How often should the board meet?" The frequency of meetings depends on a number of factors, including the size and complexity of the transaction, as well as whether any conflicts of interest exist. In some situations, it may be advisable to schedule several meetings over a period of weeks to update directors on the status of a proposed transaction. If it turns out that some of the scheduled meetings are not needed, they can simply be canceled.

What's important is that the record shows that the directors took the time to understand the transaction and determine whether the transaction really is in the best interest of the shareholders. In certain smaller and less complicated transactions, two meetings may be sufficient. In larger, more complicated transactions, directors may need several meetings to effectively satisfy their fiduciary obligations.

To understand the importance of the deliberation process, imagine how a jury might react on hearing that the board's due diligence review consisted of nothing more than listening to the CEO's oral presentation during one undocumented phone meeting, followed by a two-hour meeting that ended with a yes vote — all completed within a one-week period.

Contrast that with a series of well-documented meetings over a month or more, meetings for which extensive written material was distributed to board members and that included two or more detailed presentations by an experienced and independent financial adviser, and a vote that did not occur on the day of the final presentation but two or three days later, after directors had time to reflect on the terms of the proposed transaction.

It is not absolutely necessary for all of these board meetings to be held in person. However, house counsel should ensure that the same procedure used for in-person meetings is followed for meetings held by telephone.

House counsel should make sure that critical topics are on the agenda for both management and the board. By distributing an agenda in advance of a board meeting, directors will be able to determine whether they will require additional time or information in order to make an informed decision.

The house counsel is often the best person to keep minutes of the meetings of management and the board of directors. More than any other party involved, the house counsel understands the company's operations and corporate culture and the legal issues the company could potentially face. Well-documented minutes, including the steps taken by the members of the board to inform themselves about the potential transaction, will help to create a record of the deliberation process to be used should lawsuits arise questioning the directors' exercise of their fiduciary duties.

Not all directors, officers or even outside counsel may agree what level of process and documentation is necessary in a given transaction. One duty of house counsel is to persuade these parties that dotting all the i's and crossing all the t's is essential both in finding fairness for shareholders and protecting the directors themselves. Directors not particularly sensitive to the new environment in which boards of directors now function may oppose house counsel's controls as overkill. However, given the current environment, this is not an argument that house counsel (or the other directors) can afford to lose.

In an M&A transaction, determining whether something is in the best interest of shareholders essentially becomes a question of whether the terms of the transaction and the consideration being offered to a company's shareholders is fair.

So: How does a director determine if a particular transaction is fair?

This is where house counsel should recommend that the board make use of outside advisers. Qualified outside legal and financial advisers can be invaluable in helping the directors satisfy their fiduciary obligations. This is one time when expense should not be spared. To be sure, cost is important, but it should be a secondary consideration used to distinguish otherwise qualified advisers. Sacrificing quality and experience for a smaller price tag could mean the difference between fulfilling and breaching the directors' fiduciary obligations.

The law is silent about when to retain a financial adviser and whether to obtain a fairness opinion. But to protect themselves and ensure that they are not breaching their fiduciary duties, more and more boards are bringing in financial advisers to deliver fairness opinions.

A very important factor to consider in choosing a financial adviser is the adviser's independence. There should be no financial or personal relationship between the financial adviser and any member of the board or management. It's true that many CEOs are most comfortable with old friends and business associates. But in the hands of a trial lawyer, such relationships may prove devastating to the company's legal defense.

The new emphasis on separateness of the financial adviser should put an end to a long-established practice. For many years, the investment banker representing a company in a transaction would also serve as the financial adviser and provide the fairness opinion, often without charge. Now, such arrangements are taboo, especially when the banker is to receive a fee contingent on the transaction going through.

Another cautionary note has to do with the experience of the financial adviser and the quality of its fairness opinions. Some financial advisers will low-ball the price to get the business; once on the job, they require additional fees as the process unfolds. Other firms employ professionals with minimal training and little experience, and their fees reflect this. Either way, the process and results are compromised. So, while price may be a relevant factor, a company will be well advised to retain an adviser that is widely known, has a broad geographic reach and has a track record of providing fairness opinions that stand up under challenge.

It almost goes without saying that a company should never retain a financial adviser that will be a "patsy." Nor should the financial adviser's fee depend on the transaction's completion. In certain situations, such as a proposed buyout by management, avoid the temptation to retain an adviser that will come up with the desired opinion. A good "strike suit" lawyer will see right through such an arrangement and likely will have no trouble convincing a judge or jury of the worthlessness of the financial adviser's advice.

It's critical that the financial adviser be brought in early enough to do a thorough job. All too often, though, the adviser is retained only a week before the board is to vote on the proposed transaction.

This has three negative results. First, as we've seen, speed in these transactions is suspect in itself. Even if an independent and qualified adviser is involved, it could later be argued that the adviser did not have time to digest all of the information and fully understand the transaction and all its ramifications. Second, it drives up the cost of the adviser's services; the company that needs a fairness opinion in a week must expect to pay rush-job prices. Third, haste lessens the likelihood that all of the factors and information involved can be obtained in time to present a detailed report to the board. Eleventh-hour efforts often result in documents with errors.

Just how early should a financial adviser be brought in? That depends on the complexity of the transaction. Four weeks is a good rule of thumb, perhaps even longer for a "tainted" transaction, such as a buyout by a management group.

In selecting a financial adviser, boards should carefully evaluate candidates' experience and performance. Candidates should give references, describe in detail how they have served other companies, and provide examples of their presentations to boards.

Contenders for the financial adviser's job should also be told, "This is what we're going to need from you. We'll want at least two presentations to the board, a preliminary one as soon as the deal's initial terms are worked out, and another shortly before the board is to vote on the final terms. We'll want you to summarize your fairness analysis for the proxy statement, and be available by phone and in person to answer questions that arise during negotiations."

Once an adviser has been selected, it should be provided with everything that it needs to determine whether the proposed transaction is fair to the shareholders. Here, the involvement of house counsel can be vital, for typically the house counsel is best positioned to facilitate this process in terms of his or her availability, and has the knowledge about the company, an understanding of the motives of all involved parties and the clout to get things done.

What's more, once the financial adviser has drafted a presentation for the board, the in-house counsel again has an important role to play. He or she must review the presentation, while it is still in draft form, to identify proprietary information — such as projections of sales and earnings — that the company does not want to become public. This information should be deleted from the written version of the presentation and delivered orally to the board. The reason for this precaution is that the SEC is increasingly requesting that not only the two-page fairness opinion letter be included in the proxy statement, but also that any attachment — in this case, the detailed presentation — become part of the public record. In fact, the SEC can require that supplemental material prepared by the financial adviser be made part of the public record, even if this material was not presented to the board.

For decades, house counsel at many companies had only a tangential role in most mergers, acquisitions and similar sale transactions. That is no longer true. In the new world of full disclosure, exhaustive documentation and attention to process, house counsel should be at the center of the action. For many, it is a new and demanding role — and one that properly fulfilled can greatly benefit the board of directors, the company and, ultimately, its shareholders.

Goldblatt is an associate at Milbank, Tweed, Hadley & McCloy LLP, in Los Angeles. His e-mail is bgoldblatt@milbank.com. Cefali is managing director at Duff & Phelps, LLC, in Los Angeles. Her e-mail is scefali@duffllc.com.

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