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Investigating strategic alternatives has been a very popular exercise for public companies in the last few years. Demand for solid cash-flowing businesses has been at an all-time high, fueled by record levels of private equity that need to be put to work, and readily available debt financing. It is little wonder that owners and operators want to test the market value of their businesses from time to time. As a result, public announcements of investigations of strategic alternatives are being made at what seems to be an accelerating pace. And for every such public announcement, there likely are many more private investigations under way. Several critical issues present themselves at the very early stages of an investigation of strategic alternatives that could have a very significant impact if a transaction is pursued. In many cases, the very early stages of this process consist of nothing more than casual conversations with one or more potential strategic partners rather than any formal comprehensive investigation. In these cases, close monitoring by counsel may not occur, so it is particularly important for directors and officers to be aware of the legal considerations that most often come to bear. The following analyzes some of the legal constraints and practical considerations most relevant to directors and officers who are engaged in such very early-stage discussions regarding strategic alternatives. In the early stages of investigating strategic alternatives, it is impossible to predict what, if any, type of transaction may ultimately be pursued. Given that the phrase “investigating strategic alternatives” is commonly considered to mean that one’s company is for sale, it should be assumed that, among other alternatives, a transaction where Revlon duties apply could result. Under Delaware case law, Revlon duties require that officers and directors undertake reasonable efforts to secure the highest price realistically achievable given the market for their company. Revlon Inc. v. MacAndrews & Forbes Holdings Inc., 506 A.2d 173, 179 (Del. 1986). Revlon duties apply when a company, or a controlling interest in a company, is being sold for cash. Courts in Delaware and many other states apply the highest scrutiny to transactions when Revlon duties apply in order to ensure that officers and directors have fulfilled their duties. One such duty is that of loyalty, which means pursuing the interests of the shareholders exclusively, without personal conflicts. Courts apply this high level of scrutiny, with the benefit of hindsight, to the fairness of the ultimate price that is agreed to and the process from which such price resulted. Actions could be taken, or not taken, even in the most informal and preliminary stages of an investigation of strategic alternatives, that later could raise issues as to whether these Revlon duties have been met. For example, in the normal case, a chief executive officer may quite properly strongly play down her company’s future growth potential in conversation with a strategic competitor. That same conversation held after her company has begun an investigation of strategic alternatives could, however, later be characterized as an attempt to lessen the likelihood of a potential sale of her company so as to keep her job. Or it might be characterized as an attempt to further her own interests to the detriment of the other shareholders by chilling interest from potential strategic partners so that an acquisition by a private equity player may be pursued, where synergies from eliminating duplicative management are less likely and generous equity packages are more common. If a transaction implying Revlon duties is ultimately undertaken, actions of those with fiduciary duties will be scrutinized from the very earliest stages of the sale process. Even if the likelihood of a transaction implicating Revlon duties is very uncertain in the early stages, officers and directors should proceed cautiously, to avoid any actions that later could be construed as conflicting with a duty to secure the highest price realistically achievable for all the shareholders. Officers or directors investigating strategic alternatives on behalf of a company must be free from actual or potential conflicts in order to fulfill their fiduciary duties. Various factors could result in a director or officer having a strong personal financial interest in a particular potential transaction that might not be the best transaction for all the other shareholders. A common scenario that raises conflict issues is management’s interest in job security and/or a new compensation and equity package from the buyer, which may vary from one potential deal to the next. This potential conflict was intently focused on by Vice Chancellor Leo Strine in the recent case In re NetSmart Technologies Inc., No. 2563-VCS, 2007 WL 1576151 (New Castle Co., Del., Ch. March 14, 2007). Strine strongly suggested that management’s interest in a transaction with private equity buyers improperly influenced the board not to fully consider potential acquisitions by strategic buyers, where the equity pool available for management might not be as deep and where target management might not be as valued after closing. “One obvious reason for concern is the possibility that some bidders might desire to retain existing management or to provide them with future incentives while others might not.” Id. at *17. Another common scenario raising potential conflicts is when a substantial shareholder’s economic motivations differ from those of the other shareholders. The investment horizon of a fund shareholder may be such that there is pressure to liquidate an investment in the near term. This interest could conflict with a desire to give the company’s long-term strategic plan time to bear fruit, which might be in the best interest of the other shareholders. Another possible conflict is when a founding shareholder with a very low basis in a large block of stock is motivated to structure a sale as a tax-deferred reorganization rather than as a cash sale, even if a cash sale would be more advantageous to the other shareholders. Officers or directors with conflicts, or even a realistic perception of conflicts, should not be negotiating on behalf of the other shareholders or taking actions, or omitting to take actions, that commit the company in its investigation of strategic alternatives. The potential for conflicts needs to be continually assessed in light of all developing circumstances during even the earliest stages of a strategic investigation. As the process continues and potential alternative courses of action become clearer, the seriousness of potential conflicts should become more recognizable. When potential conflicts become sufficiently serious it may become advisable to shield those directors with the potential conflict from the investigative process. Forming a special committee Utilization of an independent committee to address transactions involving conflicts for some directors has become increasingly prevalent. There are some situations when actual conflicts are so apparent that the use of a special committee is clearly mandated, such as when the acquiring entity is partnering with management or members of the board to acquire a public company, or when a director (or his or her affiliate) proposes a refinancing of the company’s debt. In these situations, it is abundantly clear that certain members of management or the board are a part of the entity that is on the other side of the table negotiating against the company and that a group of directors with no interest in the transaction must negotiate the transaction on behalf of the company and its other shareholders. In the preliminary stages of the investigation of strategic alternatives, however, it is often much less clear that a conflict situation exists because of the broad array of possible transactions that may ultimately be considered. In some possible transactions, a conflict would clearly exist but in others it clearly would not, and there is no reasonable way to predict which of these possible transactions will in fact be pursued or even seriously considered by the company. Given that managers may have a differing economic incentive from other shareholders with regard to their continued employment and their compensation/equity package after a transaction, the safest course is for managers not to control or even participate in the earliest phases of the process of investigating strategic alternatives. Removing managers from this process altogether avoids the potential for later claims that they influenced the process toward or away from particular transactions because of these personal economic incentives. On the other hand, managers often have much to offer in the preliminary stages of an investigation of strategic alternatives, as they may be in the best position to devote the necessary time to the process and may have the deepest knowledge of the strengths and weaknesses of the company and of potential strategic bidders. When it is not certain that a transaction will be pursued at all or, if pursued, whether any potential conflicts will ever arise, some boards opt to include management in the investigative process and at times even have management leading the early stages of the process. While it is possible for management to lead the early stages of identifying potentially interested parties and gauging their interest, this is only advisable under very controlled conditions. The first is that the board must always be fully informed as to any material developments in the investigation. Without full knowledge of whom is being talked to and about what, the board cannot be in a position to make an informed decision as to when it becomes advisable to form a special committee to take over such negotiations. The board should also insist that management defer any discussion of any personal financial transaction with any potential strategic partner until such time as the board or its committee is actively controlling the process. As soon as managers begin to discuss their post-agreement employment and equity arrangements, their interests begin to vary from those of the shareholders. Finally, managers in these circumstances should understand that they have no authority to commit the company with respect to any potential transaction, or to pursue or not pursue any potential transaction. Despite these controls on a management-led process, many boards prefer to control the investigation of strategic alternatives from the very earliest stage, involving management as appropriate. One common means of doing so is to form a transaction committee of the board (as distinguished from an independent committee formed for the purpose of avoiding conflicts) with the CEO or other management directors as active members. This has the advantage of providing a more formal structure for directors to control the investigative process and to receive regular communications regarding the course of the investigation, while at the same time gaining the benefits of management’s insights and involvement. It may still become advisable as a transaction proceeds for management to be excluded from any activities of the committee if real or perceived conflicts should develop. This would clearly be the case, for instance, if management were invited to join a bidder group involved in negotiations with such a committee. Confidential information Providing nonpublic company information to potential acquiring entities in the very early stages of a strategic investigation can be a sensitive area. Involvement by the board as opposed to management acting without board oversight is typically advisable, and is essential if confidential information is being provided to an entity with which management is partnering or has any reasonable possibility of partnering. When there is no expectation of management participation in the bidding group, it is not uncommon for managers to proceed to prepare, negotiate and enter into confidentiality agreements without board involvement, not fully appreciating the potential significance of their actions. This can lead to problems if a strategic transaction is ultimately pursued. Maintaining a level playing field for all potential acquirers demonstrates that the process is appropriately designed to secure the highest sale price possible. The same quantity and quality of confidential information given to one potential bidder should be given to all, and it should be provided under comparable terms and conditions. This requires that the basic form of confidentiality agreement be settled when it is first provided in what could develop into a process involving multiple potential bidders. The board should be involved in this process, as the form of agreement could ultimately be used with a bidder group that is partnering with management or board members. While most terms of a confidentiality agreement are fairly standard and non-controversial, there are several that can vary widely and have the potential for a very serious later impact on the company. These terms include whether the confidentiality agreement contains a standstill clause or a prohibition against poaching of employees, and whether these provisions are as strong as they could or should be. The company’s position on these terms, both in the context of the initial agreement and in later negotiations, should be well thought out and consistent across multiple bidders. Given that some of these agreements may be negotiated with bidders that are or may be partnering with management, it is advisable for the board to apply its imprimatur to the terms of such agreement prior to its use. Officers and directors involved in the early stages of a strategic investigation should recognize that they are embarking on what could become a long and tortured journey implicating the highest level of judicial scrutiny. If a sale of their company is ultimately pursued, what they considered to be casual dinner conversation or a simple decision to meet one potential partner and to put off another may become the focus of a judicial proceeding, even if these events occur long before a decision to seriously pursue a sale of the company is made. In this atmosphere, it is necessary for conflicts, or the possibility that a judge or plaintiff may later perceive a conflict, to be continually assessed and evaluated. While difficult to pin down with any certainty, at some point the perception of potential conflicts crosses from the ephemeral to the real. Those engaged in the early stages of investigating strategic alternatives need to develop an ability to “know it when they see it,” because that is the point when it becomes advisable to wall off the potentially interested directors from the transaction through a special committee. David A. Stockton is a partner in the corporate department of Atlanta’s Kilpatrick Stockton. He advises businesses in all aspects of corporate finance and has represented numerous boards of directors and special committees in considering conflict transactions.

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