Inside M&A - November/December 2009

November/December 2009

The Effects of Anti-Money-Laundering Legislation on UK M&A Transactions 

Effective January 1, 2010, MOFCOM Implements Strengthened Rules for Merger and Acquisition Reviews

New Signposts and Practical Pointers for Directors in Troubled Times 


The Effects of Anti-Money-Laundering Legislation on UK M&A Transactions
By Nicholas Azis

A number of features are emerging in the UK M&A market following the downturn in deal activity over the last year.  Most notably, aside from sectors such as natural resources and commodities, which so far have been resilient to the downturn, many target businesses remain distressed, are divisions of a distressed group, or are in emerging markets in which local economic growth is stronger.

In terms of process, where there are sales, there are fewer formal contested auctions, and where there are auctions, there are fewer bidders than there were two years ago.  There are also more negotiated transactions occurring outside the traditional, investment-bank-driven auction scenario.  As a consequence, buyers tend to have the upper hand in negotiations and transaction pace tends to be more measured.  Buyers are proceeding cautiously while conducting deeper and more protracted due diligence investigations to verify valuation and to eradicate risk.

The nature of a target company as distressed—or as coming from or conducting its activities in an emerging market—heightens the need for thorough due diligence.  In some cases, there may have been a breakdown in management effectiveness or, in a distressed-company situation, a reduction in necessary investment.  In other cases, particularly in emerging markets, the company may have been operating in a jurisdiction that is regulated more loosely, thereby enabling questionable business practices.

As a consequence, compliance and corruption risk in cross-border transactions is being taken much more seriously in the United Kingdom and under English law.  This is particularly true in light of the recent move toward consolidation of UK law in relation to money laundering and bribery offenses.

Buyers of businesses are exposed to potential liability twice with regard to UK legislation:  first, during the due diligence process itself, if they become aware that the target has been conducting activities in relation to which the Proceeds of Crime Act 2002 (POCA) applies; and second, under new offenses that may be enacted following implementation of the Bribery Bill of 2009, which will replace common law and statutory offenses with a single piece of legislation and which will make prosecution by UK authorities much more straightforward.

Money Laundering
Although POCA is principally aimed at money laundering in relation to serious organized crime—it seeks to prevent money derived from terrorist financing, drug trafficking and serious organized crime from being "laundered" through legitimate commercial activities—the scope of the legislation in fact goes far beyond what most people would ordinarily regard as money laundering.

Two types of offense are created by POCA.  The first offense includes the following:

• Concealing, disguising, converting, transferring or removing criminal property from the relevant jurisdiction
• Entering into or becoming concerned in an arrangement in which the person knows of or suspects or facilitates (by whatever means) the acquisition, retention, use or control of criminal property by or on behalf of another person
• Acquisition, use or possession of criminal property

These offenses may be committed by anyone.  A person has a defense to these offenses if he or she makes a disclosure to the UK Serious Organised Crime Agency (SOCA) and obtains appropriate consent.

The second offense applies to certain categories of advisors that have additional duties under POCA, including organizations and individuals such as lawyers, investment banks and accountants that are used as intermediaries in transactions.  POCA defines all these organizations as being in the “regulated sector,” and they are required to notify SOCA of any money laundering activity which they encounter in the course of their professional activities.

UK money laundering legislation is specifically relevant to M&A transactions for the following reason:  any asset is considered criminal property if it constitutes a person's benefit from criminal conduct.  It is not relevant who carried out the criminal conduct, who benefited from it and whether the conduct occurred before or after POCA came into force.  It is also irrelevant whether the person benefiting from the crime or otherwise engaged in the laundering knows or suspects that what he or she is doing constitutes money laundering.  The only question is whether or not the person has benefited or is benefiting from criminal conduct.

The definition of criminal conduct in POCA is not limited to “serious organized crime.”  This means that POCA not only covers “ordinary” criminal activity, it also applies to criminal offenses under UK law that would not ordinarily be regarded as being connected with money laundering.  For example, in the United Kingdom, regulatory breaches will often constitute a criminal offense.  This means that water pollution; company law offenses; competition law offenses; consumer offenses; food, health and safety law offenses; tax offenses; immigration offenses; and the failure to hold or obtain waste licenses are all considered criminal offenses.  All of these “regulatory” breaches potentially fall within the scope of the money laundering regime, either because the cost of not obtaining the permit has been saved, an investment has not been made to comply with regulations, or the relevant tax has not been paid.  In addition, the proceeds of the sale of the target itself would constitute a benefit to the seller derived from criminal behavior.

There is no materiality threshold contained in POCA.  Therefore, given that the money laundering regime encompasses all criminal offenses, there is a real likelihood that in any M&A transaction, matters will be identified as part of due diligence that will require a disclosure to SOCA and receipt of appropriate consent in order to proceed.  Even if a matter has no commercial significance because it is trivial or easily remediable, it may still need to be reported to SOCA.  Professional advisers—as members of a regulated sector—are required by law to report the matter to SOCA, with failure to do so being an offense under POCA.

If, during due diligence, a buyer discovers regulatory breaches by a target company that technically amount to a criminal offense, what should it do?  It should make a disclosure to SOCA requesting consent to proceed with the transaction, since doing so is a defense to the offense of money laundering, if the person makes an authorized disclosure and obtains the appropriate consent to commit the money laundering act before doing so.

Once the disclosure has been submitted to SOCA (usually electronically, through a law firm), SOCA has seven working days in which either to refuse or to grant consent to proceed with the transaction.  If SOCA fails to respond within that period, it is lawful to proceed on the expiry of that period.  If consent to proceed is denied, then SOCA has another 31 calendar days in which to take further action, during which period no further step in relation to the transaction may be taken.  Consequently, it is possible that a party can be precluded from consummating a transaction for at least 40 calendar days.  Generally, however, consent to proceed in relation to regulatory offenses and "technical" money laundering breaches are given before the initial seven working day period, and often within 24 or 48 hours.  Consent may be given subject to the buyer undertaking to stop the relevant behavior, but consent will not protect target management who may have been engaged in the related activities.

It is, however, essential that the transaction is not signed before an authorized disclosure is made and appropriate consent is obtained—otherwise a criminal offense in the United Kingdom will be committed.

Can the buyer notify the seller, target or its advisers of the state of affairs?  No, it cannot, as it is considered a “tipping off” offense for the buyer or its advisers to inform the seller of their knowledge or suspicion that a money laundering offense has been or is in the course of being committed.  This is designed to avoid prejudice to any potential criminal investigation.  Instead, the only permitted course is for the buyer and its advisers to make disclosure to SOCA and to seek consent to inform the seller.  It may well be the case that the seller's advisers have already disclosed the criminal conduct to SOCA so that they can continue with the transaction on behalf of the seller.

In terms of publicity following a disclosure to SOCA, there is no duty on SOCA to keep the matter confidential and, typically, there is no public disclosure of the matter.  SOCA is also under no statutory duty to disclose whether it proposes to investigate the matter itself or whether it has notified another agency of the matter.  Finally, SOCA is not obliged to inform anyone whether it considers the matter closed.

Bribery Bill
The Bribery Bill, which is likely to come into force in the United Kingdom during 2010, draws together a number of disparate common law and statutory offenses into one coherent piece of legislation and has been drawn up following widespread criticism that the UK authorities were not taking adequate steps to combat abuse in commercial transactions.  This new legislation will make it more straightforward for UK authorities to prosecute bribery in business transactions and will be among the most comprehensive anti-corruption laws in the world.  It will create the following new offenses:

• Offering, requesting or receiving bribes by individuals or companies
• Bribery of foreign public officials
• Negligent failure by companies to prevent bribes being paid on their behalf
• Criminal liability for senior management where their companies carry out bribery with their consent or connivance

These offenses apply to UK individuals, companies and residents, and cover foreign individuals or corporations where an offense is carried out in the United Kingdom.  The legislation, which will apply extra-territorially, will go well beyond the scope of the U.S. Foreign Corrupt Practices Act of 1977, since it applies to bribery of any individual and not just foreign government officials.


Effective January 1, 2010, MOFCOM Implements Strengthened Rules for Merger and Acquisition Reviews
McDermott Will & Emery has a strategic alliance with MWE China Law Offices, a separate law firm based in Shanghai.  This article was authored by MWE China Law Offices lawyers Henry (Litong) Chen and Jacqueline Cai.

On July 15, 2009, the Chinese Ministry of Commerce (MOFCOM) enacted the Measures for the Notification of the Concentration of Business Operators (Notification Measures) and the Measures for the Examination of the Concentration of Business Operators (Examination Measures).  These procedural measures were made public on November 27, 2009, and will come into effect on January 1, 2010.  Both measures are pursuant to the Anti-Monopoly Law of the People’s Republic of China (AML) and the Regulations of the State Council on the Criteria for Notification of Concentrations of Business Operators (Regulations).

The Notification Measures set forth filing guidelines for corporations that wish to merge with or acquire other corporations.  The applicant corporation must submit a variety of legal and technical documents for review by MOFCOM, including notification letters, statements regarding the effects of the merger or acquisition on relevant markets and competitors, and the previous year’s financial statements, among other documents.

The Examination Measures delineate the procedure for MOFCOM’s investigation of the proposed concentration’s possible market and competitive effects.  If the combined revenue of the applicant corporation (or corporations) and target corporation (or corporations) exceeds a certain threshold, the case is examined by MOFCOM, regardless of the planned concentration’s market effects.  During the examination process, MOFCOM reviews the possible market and competitive effects of the concentration, analyzes the defending arguments of the relevant corporations, and can solicit the opinions of invited outside experts or other governmental agencies. 

If the proposed concentration is not rejected outright, MOFCOM can design restrictions that the applicant businesses must implement in order to gain regulatory approval.  Companies may be subject to both structural restrictions, including divestiture of businesses or other assets, and behavioral restrictions, such as licensing of key technologies and terminating exclusive agreements.  These restrictions are designed to eliminate the negative effect that the merger or acquisition has or may inflict upon market competitiveness.

Legal Implications
Over the course of drafting these measures, MOFCOM made several noteworthy changes to the method used to calculate the revenues of applicant firms.  These changes are likely to push revenues of business operators over the filing threshold and, as a result, may expand MOFCOM’s control over global mergers and acquisitions.

Firstly, MOFCOM expanded the immediate geographical area that falls under its jurisdiction.  The draft form of the Notification Measures did not include turnover from Hong Kong, Macao and Taiwan in the aggregate turnover of assets held by business operators within China.  However, this provision was changed for the final version of these Measures to include turnover from Hong Kong, Macao and Taiwan as part of the turnover for assets held in China.  This will increase the domestic turnover of business operators, therein making the filing threshold easier to reach.

In addition, MOFCOM increased the time-constraint regulations for revenue thresholds from one year to two years by ruling that multiple transactions implemented between the same business operators within a two-year period are in fact counted as a single transaction.  Once again, this will increase the number of transactions subject to MOFCOM’s review, because these transactions will more easily exceed the turnover threshold.

Practical Implications
These regulatory changes are indicative of larger changes in how MOFCOM views its role as a global regulatory body.  MOFCOM’s newfound willingness to assert itself via the use of controversial review factors and a more pronounced role on the global stage is easily demonstrated in two landmark cases:   The Coca-Cola Company’s proposed acquisition of China Huiyuan Juice Group Ltd., and Panasonic Corp.’s conditional merger with SANYO Electronic Co., Ltd.  These cases not only illustrate MOFCOM’s intention to uphold anti-monopoly regulations, but also serve as a warning to foreign corporations contemplating offshore mergers or acquisitions that may affect China.  Such corporations should anticipate a more assertive review by MOFCOM, especially as MOFCOM expands its remedies and conditional policies to include greater protection of small to medium-sized enterprises worldwide, increased responses to domestic outcries over the loss of “national brands” and heightened jurisdiction of assets held outside of China. 

The Coca-Cola Company and China Huiyuan Juice Group Ltd.
In 2008, The Coca-Cola Company moved to expand its operations in the fast-growing Chinese beverage market with a US$2.5 billion bid for the major Chinese juice maker, China Huiyuan Juice Group Ltd.  With little explanation, MOFCOM denied the proposed acquisition, stating that it would negatively affect the development of the fruit juice industry in China by increasing barriers to entry for potential competitors and damaging consumer rights by way of the elimination and restraint of competition. 

MOFCOM also noted that “Coca-Cola has the ability to transmit its dominant power in the carbonated drink market to the juice drink market by tying and bundling the juice drink with the carbonated drink or attaching exclusive transaction conditions.”  This principle, known as the “conductivity principle,” was cited in Caijing’s March 2009 article “How the Coke-Huiyuan Deal Fizzled Out” as one of the prime reasons for the deal’s failure.  Put simply, this principle states that a company’s dominance in one market can be transmitted to a related market via leverage, “brute” financial force or brand-name recognition in the first market.  While this principle has been directly or indirectly cited in Australian, European and U.S. anti-monopoly rulings, a strong consensus exists that this principle must be used prudently.

In a peculiarly similar case concerning Coca-Cola, the Australian Competition and Consumer Commission (ACCC) ruled that Coca-Cola Amatil Ltd.’s (CCA’s) proposed acquisition of Berri Ltd. would harm the Australian fruit juice market through the decrease in competitive forces via CCA’s dominant market share in the carbonated drink market.  ACCC supported its judgement by stating that CCA “would have the ability and incentive” to leverage its dominant position in the carbonated drink market to increase distribution of Berri’s fruit juices to the exclusion of rivals.  To achieve this leverage, CCA could utilize both its market dominance in carbonated drinks and its “unrivalled network” of in-store refrigeration equipment, upon which many retailers depend.

While the Coca-Cola/Huiyuan case is quite similar to the CCA/Berri case, the critical difference between the two concerns the leverage options available to Coca-Cola.  In the Australian case, CCA’s pre-eminence in in-store refrigeration equipment would allow CCA to actively leverage retailers by bundling or tying Berri products with CCA’s products, either through contractual agreements, discounts and rebates, or through restrictions on the use of in-store refrigeration units to the exclusion of rival products.  Additionally, ACCC’s assessment found that retailers would have natural incentives to bundle CCA’s and Berri’s products together in order to reduce transaction costs by purchasing from a single seller, to reduce logistics costs and to attain in-store refrigeration at a minimal cost.

MOFCOM did not publicize analytical information regarding the leverage scenario in the Coca-Cola/Huiyuan case.  While Coca-Cola could use its strong brand name to the disadvantage of competitors, concrete proof over the likelihood and practicality of this scenario is still lacking.  Taken together, MOFCOM’s apparent lack of factual support for the “leverage argument” and the “brand name power argument” leaves much to be desired and essentially makes this seemingly not-well-reasoned decision appear aggressive to firms looking into a possible merger or acquisition.

Additionally, MOFCOM’s inclination to protect small and medium-sized domestic enterprises for the “healthy development” of the fruit juice industry in China has been criticized as overly aggressive because of the lack of supporting facts and figures. 

Panasonic Corp. and SANYO Electronic Co., Ltd.
MOFCOM’s increasingly strict application of the AML to foreign companies is further supported by its October 2009 conditional approval of the merger between Panasonic Corp. and SANYO Electronic Co., Ltd.  This is the first time the Chinese competition authorities have compelled disposals outside of China in a transaction involving two non-Chinese businesses.  Since both Panasonic and Sanyo are global companies, the closing of this transaction was subject to certain conditions, including clearance by regulatory authorities around the world.  However, relative to other international regulatory bodies, MOFCOM imposed more severe approval conditions for the proposed merger.

After nine months of deliberation, MOFCOM explained that a merger between Panasonic and Sanyo would create an entity with significant market share in three key battery-product markets and that buyer-side power and the existing competitive dynamics in the industry would be unable to counter the anticompetitive impact of the merger.

MOFCOM’s ruling, in its most general form, stipulated that both Sanyo and Panasonic must divest some of their Japan-based battery businesses to a third-party buyer and that Panasonic must reduce its ownership interest in Panasonic EV Energy Co., Ltd. (PEVE, a joint venture with Toyota), in addition to waiving its right to appoint directors and vote in PEVE’s shareholder meetings.  The implementation of these regulations is subject to examination and approval by MOFCOM.

The Panasonic/Sanyo decision adds credence to the idea that MOFCOM is becoming more aggressive in asserting its jurisdiction and in enforcing the AML with respect to offshore transactions.  This case represents the first time that MOFCOM expanded its conditions and remedies to include parties’ overseas assets.  Both firms were required to divest overseas physical assets, and Panasonic was forced to reduce its ownership of an overseas entity.  Previous to this judgment, MOFCOM had focused only on a party’s assets and interests in China for clearance of offshore transactions. 

This ruling also demonstrated that MOFCOM is becoming more confident and sophisticated in administering offshore transactions that involve China.  Relative to earlier decisions, MOFCOM provided a very detailed report on the investigation of and reasoning behind its Panasonic/Sanyo ruling.

Advice to Businesses
In the future, foreign companies contemplating offshore mergers and acquisitions that may potentially affect China should anticipate a more assertive review by MOFCOM—and prepare for a more robust and aggressive reincarnation of MOFCOM itself.

Click here for an unofficial translation of the Measures for the Notification of Concentrations of Business Operators. 

Click here for an unofficial translation of the Measures for the Examination of Concentrations of Business Operators.


New Signposts and Practical Pointers for Directors in Troubled Times
By Morgan Walbridge and Dennis J. White
This article was originally published in volume 27, number 3 of Inside (Winter, 2009), a publication of the Corporate Counsel Section of the New York State Bar Association.

The current economic distress has put immense pressure on corporate boards of directors to consider and address the financial and operational challenges faced by their companies.  Moreover, directors are often forced to weigh difficult choices among alternatives that are less than optimal, all under tight time constraints and under heightened scrutiny by shareholders and other stakeholders.  This high stakes environment has generated a recent series of judicial decisions that focus on directors’ fiduciary obligations and provide guidance on how directors should conduct themselves in these difficult times.  Examination of these cases also yields practical pointers on how corporate counsel can advise directors so as to reduce their risk of personal liability. 

Duty of Oversight:  Monitoring Business Risk vs. Fraudulent or Unlawful Activity
In distressed times, companies are more apt to suffer financial losses and experience other difficulties.  When a company experiences significant adversity, it is not unusual for a group of shareholders to bring allegations that the blame should be borne by the directors for having breached one or more of their fiduciary duties.

One such duty, the duty of oversight, was recently discussed by the Delaware Court of Chancery in a derivative suit brought against current and former directors of Citigroup.  The suit alleged that the directors breached their fiduciary duty of loyalty for “(1) failing to adequately oversee and manage Citigroup’s exposure to problems in the subprime mortgage market, even in the face of alleged ‘red flags’ and (2) failing to ensure that the Company’s financial reporting and other disclosures were thorough and accurate.” ^[1]  The “red flags” alleged by the plaintiffs were largely in the public domain (including news articles and credit agency ratings) and reflected worsening economic conditions, a continuing decline in the subprime and credit markets, and the resulting impact on financial institutions. 

Typically, boards of directors are protected in exercising their duties by the so-called business judgment rule.  The business judgment rule insulates directors from liability relating to their duty of care so long as they act on an informed basis, in good faith, and in the honest belief that their actions are in the company’s best interests.   

In bringing their claim, however, the Citigroup plaintiffs relied on Caremark Int’l Inc. Derivative Litigation^[2] and its progeny which clarified a director’s “duty of oversight.”  While the court in Caremark interpreted the duty of oversight broadly, requiring directors to ensure that an adequate corporate information and reporting system exists, the court also indicated that “where a claim of directorial liability for corporate loss is predicated upon ignorance of liability…only a sustained or systemic failure of the board to exercise oversight…will establish the lack of good faith that is a necessary condition to liability.”^[3]  The Caremark standard for directors was later affirmed in 2006 in Stone v. Ritter^[4] in which the Delaware Supreme Court further clarified that a showing of bad faith is an essential element in proving oversight liability.  As the Delaware Supreme Court further explained in Stone: “Where directors fail to act in the face of a known duty to act thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.”^[5] 

In applying the learning of Caremark and Stone, the Delaware Court of Chancery in Citigroup found for the directors and refused to permit the case to proceed.  The court labeled the suit as one that “essentially amounts to a claim that the director defendants should be personally liable to the Company because they failed to recognize the risk posed by subprime securities.”^[6]  The court noted that Citigroup had in fact established procedures and controls to monitor risk, including the establishment of an audit and risk management committee.  The court focused on the extremely high burden that the plaintiffs carried in order to rebut the presumption that the directors acted in good faith and cited Chancellor Allen’s observation in Caremark that “director liability based on the duty of oversight is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”^[7]  The court found that the plaintiffs had failed to plead particularized facts demonstrating that the directors acted in bad faith and consciously disregarded their fiduciary duties.^[8]  The opinion noted that failing to dismiss the plaintiff’s claim would risk undermining well settled policy of Delaware law by placing courts in the position of essentially second guessing directors’ business decisions.^[9]

In finding for the defendants, the Chancery Court essentially ruled that Citigroup was not a Caremark type case.  Apart from finding no evidence of bad faith, the court observed that “significant differences exist between failing to oversee employee fraudulent or criminal conduct and failing to recognize the extent of a Company’s business risk.”^[10]  In fact, the same month as Citigroup, another judge on the Chancery Court allowed a “failure to monitor” claim to survive a motion to dismiss.  In that case, the Chancery Court cited well-pled allegations of pervasive, diverse and substantial financial fraud and allowed the suit to proceed.^[11]

Board Duties in a Sales Transaction
In these distressed times, boards are more frequently facing the difficult question of whether a distress sale of the business is the only option reasonably available, except for outright liquidation.  For example, private equity firms typically lack resources adequate to allow them to support all their troubled portfolio companies. Their principals must decide which companies they will support, which they will sell and which they will abandon.  Also, sales in a down market will result in reduced purchase prices which may prompt stockholders and creditors to question whether a particular sale was at fair value.  Against this backdrop, several recent cases have addressed the duties of directors in sales transactions.  

(a)  Fiduciary Duties to the Common vs. the Preferred Holders
The decision by the Delaware Court of Chancery in In re Trados Shareholder Incorporated Litigation^[12] makes it clear that, in considering any change in control transaction, directors, particularly private equity-appointed directors, must take care not to favor the interests of the preferred stockholders where they diverge from the interests of the common holders.

In re Trados involved the sale of a company in a transaction where Trados’ preferred stockholders received $57.9 million to satisfy most of their liquidation preference, management received $7.8 million in incentive compensation and the common stockholders received nothing.  Certain Trados common stockholders brought an action for breach of fiduciary duty, alleging the directors favored the interests of the preferred stockholders either at the expense of, or without considering, the common stockholders.  The plaintiffs asked why the company, which was meeting its financial plan, had to be sold at the point in time chosen by the board.   

The Court of Chancery refused to dismiss plaintiff’s fiduciary duty claims.   The court cited prior case law holding that directors owe fiduciary duties to preferred where the right claimed by the preferred is a right shared equally with the common.  Where this is not the case, the court held it is the board’s duty to favor the interests of the common stock.  Because the interests of the preferred and the common stockholders clearly diverged with respect to a sale (most notably since the common would receive zero consideration from the sale), the court held that plaintiffs could avoid dismissal if there were reasonable facts to demonstrate that directors lacked independence.  The court then found that appointment of four directors to the board by private equity firms with major holdings of the preferred stock, the employment or ownership relationship between such directors and firms and the fact that another director was the CEO with a bonus tied to the sale price were sufficient to support a reasonable inference that such directors had a personal interest in the sale decision, thereby rebutting the presumption of the business judgment rule.  The court did not make a final determination of liability, but it did allow the case to move forward.  

(b)  Recent Interpretation of Revlon Duties
In sales transactions during distressed times, directors should be especially cognizant of their duties first established by the landmark case of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.^[13]  The Revlon ruling, issued in 1986, requires directors in a change in control transaction to maximize the value of the company and secure the best available price for the stockholders under the circumstances.  In March of this year, the Delaware Supreme Court issued its opinion in Ryan v. Lyondell Chemical Co.^[14] which provides clarification as to the extent and triggering of such duties.   

In Lyondell, stockholders brought an action claiming that the board’s hasty approval of the company’s sale breached the board’s Revlon duties.  The Delaware Court of Chancery denied the defendant directors’ motion for summary judgment, noting that the deal had been approved in less than seven days and that the board had performed no market check and also agreed to substantial deal protections for the buyer.  Applying the precedent set forth in Stone that the fiduciary duty of loyalty is breached where the board demonstrates “a conscious disregard for their responsibilities” and a failure “to discharge that fiduciary obligation in good faith,”^[15] Vice Chancellor Noble was troubled by the above noted aspects of the sales process and refused to grant the directors summary judgment.   

In March, however, the Delaware Supreme Court unanimously reversed the lower court’s ruling.  The opinion of the Delaware Supreme Court found that although the Delaware Chancery Court had properly stated the principle that bad faith and a breach of loyalty can be based on a conscious disregard of a known duty, the lower court erred in the following respects: (1) finding Revlon duties applied even before the directors had decided to sell the company, (2) requiring a specific process to satisfy Revlon duties, and (3) by “equat[ing] an arguably imperfect attempt to carry out Revlon duties with a knowing disregard of one’s duties that constitutes bad faith.”^[16] 

The decision of the Delaware Supreme Court is especially helpful to directors in its clarification of two points: (i) that Revlon duties arise only when a company “embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control”^[17] and not simply because a potential acquirer has indicated interest in pursuing an acquisition; and (ii) there is “no single blueprint” for how a board must discharge its Revlon duties.^[18]  The court recognized that each transaction poses a unique set of circumstances that may require different means to satisfy the directors’ fiduciary obligations.  The ruling evidences the Delaware Supreme Court’s deference to the business decisions of boards in the context of a Revlon transaction, at least when such decisions are judged under the duty of loyalty and good faith standard. 

Practical Implications and Pointers
In addition to clarifying and refining legal principles regarding director liability, these recent Delaware cases, upon further examination, are also a source of some practical pointers on how corporate counsel can help reduce the risk of personal liability for directors through appropriate advice and specific preventative measures, including the following:

1.  Establish Appropriate Oversight Policies and Procedures
The board should confirm that appropriate oversight policies and procedures have been established and that active monitoring is taking place.  Such policies and procedures should be re-evaluated periodically to ensure that they are responsive not only to external and operational risks, but also to the threat of potential fraud or violations of law by management or employees.  For example, the court in Citicorp gave great weight to the fact that the board had established an active audit and risk management committee to help assess the risk related to mortgage-backed securities.

2.  Review the Scope of Indemnification Coverage
In both Citigroup and Lyondell, the companies had elective language in their charters pursuant to Section 102(b)(7) of the Delaware General Corporation Law that exculpated the directors from personal liability for breach of their fiduciary duties except for breaches of the duty of loyalty or actions or omissions not in good faith or that involved intentional misconduct or a knowing violations of law.  Corporate counsel should confirm the board is fully protected to the full extent allowed under the applicable law.  Absent such provisions, director actions would also be judged under the duty of care.  Since D&O insurance policies are far from standard, corporate counsel should also have the company’s D&O policy reviewed by an expert to ensure that the coverage for the individual directors and officers is adequate and that the appropriate endorsements have been secured.  In particular, it is possible to purchase separately a Side A policy that covers only the directors or non-company directors and helps avoid depletion of coverage resulting from claims against the company and delay of payments in a company bankruptcy.

3.  Be Watchful of Situations Involving Director Self-Interest
Even an exculpatory charter provision does not afford protection where the director acts out of self-interest.  In such situations, a director’s good faith is called into question and he no longer enjoys the presumption of the business judgment rule.  In such situations, a director should recuse himself from deliberations where the matter in question is being discussed or decided so as not to taint the decision-making process and compromise the independence of the other directors.  In certain cases it may be appropriate to appoint a special committee of independent directors to address a particular transaction or matter to ensure the business judgment rule still applies.

4.  Anticipate Litigation and Avoid Non-Privileged Communications
Directors should be counseled that if suit is brought, all communications among the board members and with management will be subject to discovery.  In the In re Trados case, several emails among the private equity-designated board members were quoted in the court’s opinion as possible evidence of self interest in selling the company.  Handwritten notes and emails (even “deleted” emails) can come back to haunt their creators.  If litigation is anticipated, corporate counsel should issue a document preservation directive.  Withholding or destroying materials can result in liability or a claim of spoliation with an adverse inference against the company or the directors.

5.  Follow a Deliberative Board Process and Document Its Implementation
While director exculpation provisions have generally been upheld, directors would nonetheless be prudent to fully discharge their duty of care.  In that regard, process is key. The board should be well informed and briefed by management.  However, the board should also feel free to conduct its own analysis, ask questions and consult with legal and financial advisors on whom it may rely.  It is important that directors take the time to make an informed decision.  Finally, the board minutes should reflect such deliberations.

6.  Be Mindful of Revlon Duties in a Sale Transaction
In a proposed sale transaction, the board should discharge its Revlon duties to secure the best available price under the circumstances.  The board should also discuss and consider the impact of the sale on all classes of equity, and if the company is insolvent or in the zone of insolvency, upon the creditors.

7.  Counsel the Board Regarding Its Duties
Corporate counsel should, on a regular periodic basis, counsel the board members regarding their fiduciary duties, and provide a refresher briefing when the board is faced with a potential sale or other matter that might attract litigation.  Document in the minutes or elsewhere, that the board has been so briefed and is aware of its duties.  If suit is then brought, counsel can then demonstrate to the court that the directors understood their duties.

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Author(s)

• Nicholas Azis
• Jeffrey Rothschild
• Jake Townsend

Practice Areas & Industries:

• Antitrust & Competition
• Corporate
• Corporate - London
• Corporate Responsibility and Governance
• International
• London
• M&A - London
• Mergers & Acquisitions
• White-Collar & Securities Defense

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