Risks to the Buyer of Fiduciary Duty Breaches by the Target in the M&A Sale Process

Attention to accretive M&A as a solution to investor pressure when growth slows has led to pressure on merger parties to “cut corners” on process that puts at risk compliance with fiduciary duties. It is critical for acquirors to take steps to assure that the boards of their targets have been complying with their duties.

Buyers in M&A transactions often overlook (or feel powerless to address) this risk that the target’s board may have breached its fiduciary duties in connection with a transaction. A buyer’s failure to account for breaches of fiduciary duties by the target’s board can lead to deal execution risk and/or post-closing liability for the buyer once it has acquired the target (together with its attendant liabilities). When considering the potential for a target board’s breach of fiduciary duties, buyers cannot rely on the typical due diligence process or customary sets of representations and warranties to determine whether such breaches have occurred. However, the buyer can take steps to minimize the risks associated with such breaches.

Conduct by the Target’s Directors and Management 

• Conflicts within the Capital Structure. In the event the target has multiple types or classes of outstanding equity, the buyer needs to be focused on the potential for conflicts that will trigger breaches of duty. For example, when members of the target’s board hold, or are affiliated with holders of, preferred stock with a preferred return or put rights, these members may be incentivized to vote in favor of a transaction in which the preferred shareholders receive a healthy payout while common shareholders are left receiving little, or nothing, in the way of merger consideration. Alternatively, in the case of a company with high-vote and low-vote stock, special consideration will need to be given to the process employed by the board of directors when the high-vote and low-vote stock receive different consideration. A court reviewing these types of transactions may apply a higher level of scrutiny to the transaction terms if it determines that board members approving the transaction were not disinterested. Buyers should consider:
  • Requiring the target to obtain the approval of the shareholders who are not associated with interested directors;
  • Requesting that the board ask the target financial advisor to provide a fairness opinion in respect of each class of stock;
  • Asking the target if it has considered running the process with a committee of independent directors; and/or
  • In the context of a private deal, requiring indemnification for claims arising in connection with a breach of fiduciary duty.

• Management Conflicts. Although buyers may view a good relationship with a CEO or other senior officers of the target as a benefit during deal negotiations, buyers should be wary of the potential for officers of a company to “get out ahead of” their board during deal negotiations. Buyers should consider taking the following steps to ensure that pre-closing discussions with a senior officer do not become an unwanted point of focus in a shareholder lawsuit:
  • Confirm that the insider is not “in front of” his or her board by addressing buyer’s written communications to the full board and getting feedback from the target’s financial advisor and outside counsel about the board’s role; and
  • Agree on material transaction terms before negotiating or having substantive conversations about the terms of any post-closing relationship with officers or directors of the target.

Conduct by the Target’s Financial Advisors

A target’s financial advisor’s failure to disclose its relationships (or potential relationships) with the buyer can also lead to claims of breach of fiduciary duty by the target board. Courts have allowed shareholders to claim breach of fiduciary duty when the target’s board allegedly failed to act in an informed manner when the board was unaware of its financial advisor’s potential conflicts, especially those involving the target financial advisors’ investments in, relationships with, and promises to and from the buyer and its affiliates. Though target boards have generally been able to avail themselves of exculpation under 102(b)(7) in the case of such claims, such claims have nonetheless exposed financial advisors to aiding and abetting claims by shareholders, which, post-closing, can result in reputational harm to the buyer as well as potential claims against the target (now as the buyer’s subsidiary) by the financial advisor for indemnification.

Buyers should be mindful of their current and potential interactions and take stock of their past interactions with the target’s financial advisor. Buyers should take steps to ensure that the target and its counsel are aware of any potential conflicts of interest on the part of the target’s financial advisor that arise from connections with the buyer and that these conflicts have been disclosed to the board.

Cleansing

Finally, to the extent buyers become aware (in advance of target shareholder approval of the transaction) of any potential grounds for breach of fiduciary duty claims against the target board, they should require that these claims be included in the merger proxy statement, so that the breaches may be cleansed by a fully-informed shareholder vote.