Directors’ Fiduciary Duties After Netsmart
by Samuel W. Wales and Monique Y. Ho
In the first quarter of this year, the Delaware Court of Chancery issued a decision that should cause directors to carefully consider whether they have done enough to canvass the market of potential acquirers when their company is up for sale or, in other words, whether they have effectively discharged their Revlon duties. In In re Netsmart Technologies, Inc. S’holders Litig., the court enjoined a proposed cash-out merger between Netsmart Technologies, Inc. and two private equity firms, Insight Venture Partners and Bessemer Venture Partners. The court held that the Netsmart board of directors and special committee each breached their fiduciary duties “to undertake reasonable efforts to secure the highest price realistically achievable given the market for the company” when they only surveyed potential financial buyers (and no strategic buyers) during the then-present sale process. The court also held that the proxy statement distributed by Netsmart to its stockholders was materially incomplete for failing to disclose the projected future cash flows used by Netsmart’s financial advisor to support its fairness opinion. However, due to the court’s concern that the buyer would walk away from the deal if it required the Netsmart board to shop the company to a broader audience, the court limited the injunction to delaying the stockholder vote on the merger until Netsmart amended its proxy statement to disclose the reasons for not exploring the market of strategic buyers and the projected future cash flows used by its financial advisor.
Netsmart was a NASDAQ micro-cap company and a leading supplier of enterprise software solutions to health and human services providers and payors. From 1999 to 2006, Netsmart’s management and its financial advisor had sporadic, unfocused discussions with several potential strategic buyers, and these discussions were met with very little enthusiasm. Following Netsmart’s acquisition of its largest competitor in October 2005, however, several private equity firms approached Netsmart, expressing interest in acquiring the company. Because of its perceived past failure to attract strategic buyers, Netsmart’s management decided against pursuing strategic buyers and encouraged Netsmart’s board of directors to focus on an expedited auction process focused solely upon potential private equity buyers. After this strategy was adopted, Netsmart’s board formed a special committee of independent directors to safeguard the interests of Netsmart’s non-management stockholders. In early 2007, Netsmart entered into a merger agreement with Insight and Bessemer. The merger agreement contained a window-shop provision that allowed Netsmart’s board to consider an unsolicited superior bid, a fiduciary out and a 3 percent break-up fee in the event Netsmart terminated the merger agreement to pursue a superior bid. After Netsmart failed to receive any higher bids, Netsmart sent out proxies calling for a special stockholder meeting to vote on the merger. Several groups of shareholders sought a preliminary injunction against the consummation of the merger, which the court granted.
The court held that the Netsmart board of directors and special committee failed to take reasonable steps to secure the highest price realistically attainable and thus breached their Revlon duties. Although the court noted that Revlon does not “require every board to follow a judicially prescribed checklist of sales activities,” the court was quite critical of the sale process used by the Netsmart board and independent committee. First, the court noted that Netsmart’s board, independent committee, management and financial advisor never made any serious attempt to survey the strategic market and develop a core list of potential strategic buyers “for whom an acquisition of Netsmart might make sense.” In this vein, the court found the small number of informal, unfocused contacts between Netsmart’s management and financial advisors, on the one hand, and potential strategic buyers, on the other hand, prior to the decision of Netsmart’s management and board to begin the sale process to be cursory and poorly documented, and distinguished such efforts from a targeted, controlled and discreet sales effort aimed at select strategic buyers.
Second, the court also noted that it was unreasonable for Netsmart’s independent committee to rely upon the window-shop, fiduciary out and break-up fee provisions in the merger agreement as a feasible method for obtaining the highest price reasonably attainable for a company like Netsmart, especially since such provisions would require a strategic buyer to publicly disclose its intent to make a superior bid without having any discussions with Netsmart’s management or any access to due diligence. While prior Delaware cases have held similar post-signing market checks to be sufficient in numerous large-cap company sales, the court found the market dynamics to be very different for Netsmart as a micro-cap public company. As a result, a post-signing market check “does not, on this record, suffice as a reliable way to survey interest by strategic players” at such a late stage in the merger process.
Lastly, the court criticized a number of company actions, including (i) the timing of the formation of the independent committee after Netsmart’s management and board approved the sales process directed at a limited number of private equity buyers, (ii) that Netsmart’s management conducted the due diligence process without supervision, and (iii) that the minutes for key meetings of Netsmart’s board and independent committee were either missing, lacked detail or were prepared months after the actual meetings.
The court also held that the proxy statement distributed by Netsmart to its stockholders was materially incomplete for failing to disclose the projected future cash flows used by Netsmart’s financial advisor to support its fairness opinion. As the court noted, it is well settled that the board of directors of a Delaware corporation must “disclose fully and fairly all material information within the board’s control when [it] seek[s] shareholder action,” and that “[a]n omitted fact is only material if there is a substantial likelihood that it would be considered important in a reasonable shareholder’s deliberation and decision making process before casting his or her vote.” In the present case, the proxy statement distributed to Netsmart’s stockholders failed to disclose the final projections of Netsmart’s expected future cash flows that were used by Netsmart’s financial advisor in support of its fairness opinion. The court found that this failure to disclose Netsmart’s expected future cash flows as of the time that Netsmart’s board approved the merger agreement was material because Netsmart’s stockholders were being asked to approve a cash-out transaction, forsake any future gains from Netsmart’s ongoing operation and waive their appraisal rights. The court thus held that the company had to disclose to the stockholders the final projections used by its investment banker to prepare its discounted cash flow model and fairness opinion.
The court in In re Netsmart did not change the holding in Revlon, it merely reiterated that there is no single approach to conducting a sale process. The particular method used in light of the specific circumstances must result in a reasonable approach to achieve the highest possible price. Based on the record presented In re Netsmart, the court found that reliance on a post-signing market check was insufficient for a micro-cap company such as Netsmart. Overall, the issues raised underscore the need to involve experienced counsel as early as possible in a transaction involving the sale of control of a company.
Use of “Big Boy” Letters
Christopher M. Zochowski
In SEC v. Barclays Bank PLC and Steven J. Landzberg, the Securities and Exchange Commission brought an enforcement action that cast further doubt upon the enforceability of “big boy” letters used in securities transactions between sophisticated parties. “Big boy” letters have generally been viewed and used as a mechanism to mitigate the risks of trading securities while in possession of material nonpublic information.
The federal securities laws generally prohibit trading in securities in breach of a fiduciary or other similar relationship of trust and confidence while in possession of material nonpublic information about the security—so-called “insider trading.” Frequently, however, parties have been willing to proceed with such trades by entering into “big boy” letters that accompany the purchase and sale documentation in which they agree not to bring suit over the non-disclosure of material nonpublic information relevant to the security. These letters generally include, among other things, an acknowledgement that one or both parties may have material nonpublic information and that neither party is relying upon the other to disclose such information. The parties usually also agree to waive any claims that either party may have against the other stemming from the non-disclosure of the material nonpublic information.
THE BARCLAYS COMPLAINT
In the Barclays complaint, the SEC alleged that Barclays Bank and Steven Landzberg illegally traded millions of dollars of bond securities over a period of 18 months while in possession of material nonpublic information received from six creditors committees as a result of Landzberg having been employed as the head proprietary trader of Barclays’ U.S. distressed debt desk and through his simultaneously serving as a representative on the committees. According to the complaint, Barclays and Landzberg misappropriated material nonpublic information obtained by virtue of their positions on these creditors committees and did not disclose their trading to the unsecured creditors committees, issuers or others that provided such information. Additionally, Landzberg and Barclays failed to disclose any material nonpublic information to their bond trading counterparties although they did, in some instances, use “big boy” letters to advise such counterparties that Barclays may have material nonpublic information in its possession. As a result, both Barclays and Landzberg consented to the entry of final judgments which permanently enjoined them from violating Section 17(a) of the Securities Act, and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Furthermore, Barclays agreed to pay a total of $10.94 million to settle the charges and Landzberg agreed to pay a $750,000 civil penalty. Landzberg further consented to being permanently enjoined from participation in any creditors committee of any federal bankruptcy proceeding involving an issuer of securities.
Since Barclays and Landzberg ultimately settled the action and consented to statutory injunctions without admitting or denying the SEC charges, the issues surrounding Barclays’ use of “big boy” letters will not be addressed by the judiciary. In addition, the facts of this case were particularly egregious. Nevertheless, the SEC’s focus on the use of “big boy” letters in trades by Barclays involving material nonpublic information appears to signify that “big boy” letters will not necessarily protect banks or their traders against government fraud enforcement actions under Section 17(a) of the Securities Act, and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The SEC emphasized this point in its litigation release which announced the settlement.
Although the SEC issued a warning regarding reliance upon “big boy” letters in the Barclays settlement, it disclosed scant detail as to how they were in fact used in these instances and the protections that the parties were attempting to achieve. Consequently, it is difficult to draw detailed conclusions from the Barclays settlement regarding the SEC’s views on the use of such letters.
Whether the SEC will continue to pursue such actions and, if so, under which circumstances is unclear. What is known is that, when considered together with pre-existing uncertainty surrounding their enforceability, parties would be well advised to carefully examine their use of “big boy” letters and the legal protections they are intending to obtain as a result of such use.
Supreme Court Toughens Scienter Pleading Standard
By Eric Landau, Shawn M. Harpen and Kristel A. Robinson
In the recent decision of Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Supreme Court of the United States set a national standard for pleading scienter in securities fraud actions brought under Section 10(b) of the Securities Exchange Act of 1934. Addressing the application of the heightened pleading standards set forth in the Private Securities Litigation Reform Act (PSLRA), the 8-1 Supreme Court decision resolves a split among the federal circuits with regard to the pleading of scienter.
To survive a motion to dismiss under the PSLRA, a plaintiff must allege with particularity facts giving rise to a strong inference that the defendant made the misrepresentations or omissions with scienter, i.e., knowingly or in a severely reckless manner. However, as the Supreme Court noted in Tellabs, the statute does not define “strong inference” and this has led to different interpretations across jurisdictions.
Through Tellabs, the Supreme Court aimed “to prescribe a workable construction of the ‘strong inference’ standard, a reading geared to the PSLRA’s twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims.” In furtherance of these goals, the Supreme Court set forth standards to be used by the district courts when evaluating the viability of a complaint.
THE TELLABS PLEADING STANDARD
First, in ruling on a motion to dismiss a securities fraud action, “courts must, as with any motion to dismiss for failure to plead a claim on which relief may be granted, accept all factual allegations in the complaint as true.” Second, courts should consider complaints in their entirety, as well as other sources of information appropriate for courts to consider on a motion to dismiss, such as documents incorporated into a complaint by reference, or public filings and other matters of which a court may take judicial notice. This language suggests that district courts will have less discretion when considering a request for judicial notice. For example, in a case involving allegations of misstatements or omissions in a proxy statement, it may now be mandatory for courts to consider the entirety of the proxy statement when evaluating a motion to dismiss. In this manner, bad facts (from a plaintiff’s perspective) can no longer be ignored at the pleadings stage, but now must be considered and weighed in deciding if the plaintiff’s story is at least as plausible as the facts contained in public filings.
The Supreme Court further explained that the inquiry for the district court is “whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.” Thus, the allegations of scienter are to be viewed holistically. It is important to note, however, that only well-pleaded, specific allegations should be considered. As the Supreme Court confirmed, “omissions and ambiguities count against inferring scienter, for plaintiffs must ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.
Finally, and most significantly, the Supreme Court held that “in determining whether the pleaded facts give rise to a ‘strong’ inference of scienter, the court must take into account plausible opposing inferences.” More specifically, a court may not only consider “inferences favoring the plaintiff,” but must also “consider plausible nonculpable explanations for the defendant’s conduct.” As the Supreme Court explained, the district court must conduct a comparative analysis of competing inferences because the PSLRA does “not merely require plaintiffs to ‘provide a factual basis for [their] scienter allegations,’. . . i.e., to allege facts from which an inference of scienter rationally could be drawn. Instead, Congress required plaintiffs to plead with particularity facts that give rise to a ‘strong’—i.e., a powerful or cogent—inference.” Thus, per Tellabs, “the inference of scienter must be more than merely ‘reasonable’ or ‘permissible’—it must be cogent and compelling, thus strong in light of other explanations. . . . [and] at least as compelling as any opposing inference one could draw from the facts alleged.”
APPLICATION OF PLEADING STANDARD
Although the Supreme Court requires courts to weigh inferences, it does not require inferences advanced by plaintiffs to be the most plausible inferences, as the Sixth Circuit had held in Helwig v. Vencor, Inc. Instead, under this new pleading standard, a plaintiff’s case will be permitted to proceed to discovery as long as, when viewed holistically, the allegations of his complaint support an inference of scienter that is at least as plausible as the inference of innocence. For most jurisdictions, other than the Sixth Circuit, the Tellabs decision will represent a tougher pleading standard to be met by the plaintiff’s securities bar.
Proposed Amendment to NYSE Rule 452 Revised
By Hal N. Schwartz
Currently, New York Stock Exchange Rule 452, the so-called “10 day broker vote rule,” permits members of the NYSE to execute and return proxy statements with respect to “routine” shareholder proposals if the broker does not receive voting instructions from the stock’s beneficial owner at least 10 days before a scheduled meeting. Among the other matters that the current NYSE Rule 452 considers routine is an “uncontested” election of a company’s board of directors. Rule 452.11(2) defines a “contest” as a matter that “is the subject of a counter-solicitation, or is part of a proposal made by a stockholder which is being opposed by management.” In recent years, an increase in the number of new types of proxy campaigns, including “just vote no” campaigns, has caused critics to question the current definition of a “contested” election. Under the existing rule, such types of proxy campaigns are not considered “contests” and broker votes are counted. As a result, critics argue, the efforts of shareholders to express disapproval of key board actions are diluted.
In April 2005, the NYSE created the Proxy Working Group (PWG) to review the NYSE rules regulating the proxy voting process. In June 2006, the PWG recommended the adoption of an amendment to Rule 452 which would eliminate discretionary voting by brokers on director elections. In its 2006 report, the PWG cited the critical importance of shareholder voting for the election of directors and ultimately recommended that the election of directors be changed from a “routine” to a “non-routine” event. The NYSE solicited and received nearly 50 responses from various interested parties, whose reactions to the proposed change varied across industry lines. Many of those concerned with the amendment argued that certain entities relied on broker votes for purposes of meeting their quorum requirements at uncontested elections. On October 24, 2006, the NYSE filed an amendment to Rule 452 with the Securities and Exchange Commission to implement the recommendation of the PWG to classify the election of directors as a “non-routine” matter. Once implemented, the revised rule would include the election of directors among its 18 other “non-routine” matters, and broker votes would no longer be counted. The NYSE filing proposes that amended Rule 452 would apply to proxy voting for shareholder meetings held on or after January 1, 2008, except to the extent that a meeting was originally scheduled to be held in 2007 but was properly adjourned to 2008.
The proposal was not without its critics. The Investment Company Institute (ICI), for example, argued that the proposed amendment would make it very difficult for mutual fund companies to achieve a quorum at special meetings, resulting in dramatically increased costs and unnecessary delay in the election of directors. The PWG’s consideration of materials submitted by ICI and by other representatives of registered investment companies led to a Rule 452 amendment with the proposed additional change, which was submitted to the SEC for final approval on May 23, 2007. As currently proposed, the amendment to Rule 452 would still add “the election of directors” to the list of “non-routine” matters, but would provide for an express exception for companies that are registered under the Investment Company Act of 1940. The PWG ultimately concluded that these entities were unique from other operating companies in that they are already subject to strict director voting rules under the Investment Company Act.
A corporate governance officer of a Fortune 100 Company (and former member of the NYSE Proxy Working Group) devised what he contends is a superior approach to avoid the potential pitfalls of proxy voting. The concept is known as Client Directed Voting (CDV) and would give retail shareholders the opportunity to pre-select their voting preferences at the time they enter into the brokerage agreement. Shareholders would be given choices within their brokerage contracts; if the shareholder failed to specify a choice, that shareholder’s holdings would be voted proportionally with the brokerage firm’s other clients who voted on the matter in question. It is proposed that shareholders who choose this option would be able to designate voting for or against the recommendations of management, abstain completely, or in accordance with the brokerage firm’s customary voting procedures. Under CDV, shareholders would be given choices on all matters, both routine and non-routine. Proponents of CDV argue that the use of CDV would alleviate quorum concerns, while at the same time ensuring that any given vote is conducted fairly and in a cost-effective manner, since issuers would no longer be forced to spend time and money tracking down votes. CDV remains merely a concept and has yet to be implemented.
Impact of New Deferred Compensation Regulations on M&A
By Joseph S. Adams and Renata Ferrari
On January 1, 2008, new regulations from the Treasury Department and the Internal Revenue Service (IRS) under Section 409A of the Internal Revenue Code will take effect. These regulations, which may be relied upon prior to January, are expected to alter M&A transactions involving a change of control.
Distributions Upon a Change in Control
Deferred compensation amounts subject to Section 409A may only be distributed upon certain specified events, such as separation from service or upon a permissible change in control. A permissible change in control for purposes of Section 409A includes a change in ownership of 50 percent of the stock of the company, a change in the ownership of 40 percent of the company’s assets, or a change in the effective control of a company. The proposed regulations provided that a change in the effective control of the company consisted of the acquisition of at least 35 percent of the total voting power of the stock of such company (or when a majority of members of the company’s board of directors is replaced during any 12 month period by directors whose appointment or election is not endorsed by a majority of the members of the company’s board of directors before the date of the appointment or election). The new regulations lower the threshold for an effective change in control to as low as 30 percent of the total voting power of the stock of such company. While not as low as the 20 percent requested by some commentators, the change is favorable because it allows a lower threshold for a permissible change in control, allowing a distribution of deferred amounts to participants.
Electing to Avoid Distributions in Certain Asset Transactions
The new regulations adopt a rule that allows service recipients (generally employers) to exercise additional control over whether a sale of assets will trigger a distribution to the service providers (generally, employees or independent contractors). The buyer and seller may now specify, under limited conditions, whether the service providers will qualify for a distribution or not, i.e., the parties may agree to apply a “same-desk” type rule prohibiting distributions. To rely upon this special rule, the asset purchase transaction must result from bona fide, arm’s length negotiations. In addition, all service providers of the seller immediately before the asset purchase transaction who would be providing services to the buyer, after and in connection with the asset purchase transaction, must be treated consistently for purposes of applying the provisions of any nonqualified deferred compensation plan. Such treatment must be specified no later than the closing date of the asset purchase transaction. The new regulation is favorable because it allows for greater control over whether a sale of assets will trigger distributions to service providers.
Terminating Nonqualified Plans Following a Change in Control
The proposed regulations provided that deferred compensation plans may be terminated in connection with a change in control, but required all substantially similar plans to be terminated—raising a question of whether the buyer had to terminate its plans. The new regulations specify that only the deferred compensation plans covering the employees of the acquired company need to be terminated and liquidated upon a change in control.
Identification of Specified Employees
Section 409A provides that with respect to a “specified employee,” a payment of nonqualified deferred compensation on account of separation from service may not occur until six months after the date of separation from service (or, if earlier, the date of death of the employee). For most larger public companies, a specified employee generally is one of the highest paid officers (up to 50) of the company or any of its subsidiaries whose compensation exceeds $140,000 (for 2006). The new regulations clear up ambiguity when one public company acquires another public company, i.e., are the two companies’ lists of specified employees simply added together so that up to 100 employees are subject to the six month delay, or are the two lists simply meshed and the highest paid 50 employees out of the combined 100 employees treated as specified employees? The new regulations clarify that the latter approach applies so that no more than 50 employees will be subject to the delay. This interpretation is favorable because post-merger integration may lead to many officers leaving the combined entity and becoming eligible for distributions of nonqualified amounts.
Granting Stock Options or Stock Appreciation Rights (SARs) Prior to an IPO or Change in Control
The regulations exempt stock options and SARs granted at fair market value that do not include any additional deferral features. However, this exemption puts tremendous pressure on ensuring that options and SARs are granted at fair market value, especially in the case of illiquid stock that is not readily tradable on an established securities market. The regulations provide a safe harbor for certain early stage companies that do not reasonably anticipate a change in control or an IPO. The safe harbor establishes a presumption that a valuation reflects the fair market value if the valuation is performed by a qualified individual and is based upon a reasonable application of a reasonable valuation method. In order to qualify for the safe harbor, the company may not otherwise anticipate a change in control within the next 90 days or an IPO of the stock within the next 180 days. These time periods were reduced from the 12 month requirement in the proposed regulations. This interpretation is favorable because it provides companies a longer period of time and greater certainty before becoming ineligible for the safe harbor.
Adjusting Equity Awards in Connection with a Change in Control
Consistent with the proposed regulations, equity awards, such as restricted stock units and phantom units, may constitute deferred compensation. As a result, unless the treatment of these awards upon a change in control is specified in a plan or award agreement, there will generally be less flexibility in adjusting or settling these awards. In addition, the method of converting options in a change in control transaction will need to be reviewed to ensure that the methodology is consistent with the requirements set forth in Section 409A. For example, the ratio of exercise price to the fair market value of the shares after the substitution or assumption cannot be greater than before. Although this is not a significant change from the proposed regulations, this issue needs to be addressed in virtually any change in control transaction. For more guidance, see http://www.mwe.com/info/news/ots0407b.htm
European Commission to Pay for Botched Merger Review
Contact Jake Townsend
On July 11, 2007, the European Court of First Instance (CFI) ruled that the European Commission must compensate a party to a business combination for certain losses resulting from the Commission’s procedural errors when it blocked a merger between two French electric companies in 2001. This is the first time the CFI has awarded damages arising from a Commission merger decision. The Commission will now be even more circumspect when investigating deals that are serious candidates for a veto. Indeed, merging parties may expect greater Commission adherence to their procedural rights in Phase II reviews, which would be welcomed.
On October 10, 2001, the Commission blocked the merger between Schneider Electric and Legrand after an in-depth Phase II EU merger review. Since Schneider had already implemented the merger before clearance, Schneider had agreed to sell its Legrand shares to a third party. In parallel, Schneider appealed the veto decision to the CFI. In October 2002, the CFI annulled the Commission’s decision on the basis that its economic reasoning for prohibiting the merger was deficient. The CFI also found that the Commission had breached Schneider’s procedural rights by failing to bring the merging parties’ attention to issues which ultimately led to the decision to prohibit the merger. Notwithstanding this annulment, the parties failed to convince the Commission that they could address competition concerns when they re-filed the merger notification with the Commission and the parties eventually decided to unwind the transaction in December 2002.
Schneider subsequently brought a claim against the Commission for damages arising from its deficient economic reasoning and breach of Schneider’s procedural rights in the Commission’s original review. The CFI upheld Schneider’s claim, but only in so far as it related to damages arising from a breach of fair process. The CFI rejected Schneider’s claim for damages arising from the Commission’s erroneous merger review. The CFI stated that the Commission enjoyed a wide margin of discretion in carrying out merger reviews, and the nature and extent of the deficient economic reasoning in this analysis did not give rise to a claim for damages. The CFI did not, however, rule out that a grave and manifest error in economic analysis could give rise to compensation in future cases. It will be interesting to see whether the CFI orders the Commission to pay MyTravel Group PLC damages for its veto of the Airtours/First Choice merger on this or on any other basis (MyTravel has reportedly brought a similar damages claim against the Commission for £518 million).
The CFI awarded damages to Schneider for the costs of suspending the divestment of Legrand by Schneider and the re-filing of the merger notification. An expert has been appointed to determine the precise cost of damages arising from the suspension of the divestment order, but this is likely to be a fraction of the original claim by Schneider. The CFI refused to award Schneider other costs, including for lost synergies, which claim (among others) is presently being pursued by MyTravel against the Commission.
Although the damages order is embarrassing for the Commission, the ruling is not likely to open the floodgates for similar damage claims against the Commission in the future. This is because such claims will only be allowed in very specific circumstances, such as when the Commission has blocked a deal and in so doing has breached the merging parties’ fundamental procedural rights. Further, the CFI seems to have raised the bar for merging parties to bring claims based on economic or other substantive Commission errors. The CFI’s damages order does, however, put greater pressure on the Commission to respect the merging parties’ rights to present counterarguments to the Commission and their other procedural rights in the merger review process. The Commission will certainly think very carefully about whether to block a business combination—and about the manner in which it will do so—in the future.