Management-led buyout (MBO) activity continues unabated. From J. Crew to Kinder Morgan, MBOs can be good for company shareholders if the company engages in a fair auction. A fair auction can occur through various means and all the stakeholders should understand the role of the Special Committee in any transaction with a perceived conflict.
Typically, when a shareholder challenges the actions of a Delaware corporation’s Board, the court will presume that decisions were made by the Board upon the exercise of proper business judgment. However, in transactions where a Board’s disinterestedness or independence is at issue, such as in the MBO or affiliate transaction context, courts may require that the Board bear the burden of showing that its actions were entirely fair to the Company, its equity holders and debt holders (Entire Fairness). If however, the Board has taken documented steps to ensure the fairness of a transaction, such as the use of a truly independent Special Committee to review and approve the transaction, then the burden will usually shift back to the shareholder to prove that a transaction was not fair. Courts will generally look to the following seven factors to determine whether a Special Committee was truly independent: (i) did the committee have sufficiently separate interests from interested directors and shareholders; (ii) did the committee have outside legal and financial advisors who had sufficiently separate interests from interested directors and shareholders; (iii) did the committee have a broad scope of authority to approve, reject, and negotiate the transaction; (iv) was the committee aware of its role and has it received full disclosures to sufficiently carry out its responsibilities; (v) was the committee actively involved in the negotiation process; (vi) was the committee large enough to engage in robust diligence and analysis of the transaction (a committee of one person is generally insufficient); and (vii) did the committee have sufficient time to analyse the transaction.
Notwithstanding the showing of a truly independent Special Committee, courts will still scrutinise a conflict transaction with much greater intensity and a Board should be able defend the Entire Fairness of the transaction by showing (a) the fairness of the transaction process (fair dealing) and (b) fair price. A court reviewing the fair dealing of a transaction will look to the details and timing of the negotiations, the degree of disclosure to directors and how approvals were obtained. A Board may use the creation of a Special Committee and its participation in the transaction as evidence of fair dealing and any of the seven ‘independence’ characteristics outlined above can be used to bolster this defense.
A Board defending the fair price of a transaction does not need to show that the price was the highest price that a bidder could afford to pay, but rather that under the circumstances, a reasonable seller would regard the price as within a range of fair value. A proper defense of the transaction price should show that a Special Committee approved the price after fairly valuing all the assets, the earnings, the future prospects and any other factors that would affect the transaction. The breadth and scope of a Special Committee’s analysis of fair price are essential factors in establishing that the transaction price is fair. One way that a Special Committee can evidence fair price is by retaining an independent financial advisor to render a Fairness Opinion. The Fairness Opinion would explain and opine as to the fairness of the price being offered. The financial advisor’s independence, diligence procedures, and especially its Fairness Opinion are key pieces of evidence in demonstrating fair price. It should be noted that a major factor in considering a financial advisor’s independence is whether that advisor stands to collect a material success fee upon closing of the transaction. Legal advisors play a crucial in overseeing the financial advisor’s independence, diligence procedures and in reviewing and commenting on the language of the advisor’s Fairness Opinion to ensure that these defensive measures are properly evaluated and not contested in court.
In sum, the role of a Special Committee is pivotal in any transaction with a perceived conflict. A committee that is structured as a truly independent committee accomplishes two key purposes: (i) under Delaware law, evidence of such committee shifts to the plaintiffs the burden to prove that the directors breached their fiduciary duties; and (ii) the existence of such committee is a key piece of evidence to defend the fair dealing component of the transaction. Legal advisors play a key role in carefully structuring and monitoring the committee and its activities. From periodic evaluation of the composition of the committee, to preparing minutes and other written materials showing a committee’s activities, to carefully reviewing and commenting on a financial advisory opinion, thoughtful legal advice can be crucial in assisting a party in successfully executing an Entire Fairness defense through a clear showing of both fair dealing and fair price.
* A version of this article was published in Financier Worldwide’s Global Reference Guide: Middle-Market M&A 2011 in April 2011.
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