The risk that a public company will face shareholder litigation stemming from an announced merger or acquisition is on the rise. According to Cornerstone Research, 91percent of deals valued at $100 million or greater from 2010 to 2011 resulted in lawsuits challenging those deals. The number of lawsuits challenging each deal also has grown from an average of 2.8 lawsuits per deal in 2007, to 6.2 lawsuits per deal in 2011, with lawsuits often filed in multiple jurisdictions.
This proliferation of litigation is costly and distracting to a company focused on consummating a deal. Whether or not your company currently is contemplating a merger or acquisition, there are several steps in-house counsel should consider to help minimize the risk and cost of future litigation.
1. Consider adding an intra-corporate forum selection clause to your company’s charter
As the number of lawsuits challenging M&A deals has risen, plaintiffs have resorted to filing lawsuits in multiple jurisdictions. As a result, litigation costs have skyrocketed and there is an increased risk of an adverse result in one of the jurisdictions in which shareholders file cases. Even before contemplating a deal, a company can proactively limit the costs and risks associated with litigation in multiple jurisdictions by amending its charter to include a forum selection clause for intra-entity disputes.
While most M&A agreements contain provisions which require that lawsuits between the parties to an agreement be filed in a specific jurisdiction, studies conducted by Stanford Professor Joseph Grundfest reveal that only a small percentage of companies are estimated to have intra-corporate forum selection clauses in their charters, that would similarly limit the venues in which shareholder challenges to these transactions could be filed.
Companies that do not have intra-corporate forum selection clauses in their charters should consider charter changes to include provisions requiring that intra-entity disputes be filed in the state of incorporation or organization. Inclusion of some form of intra-corporate forum-selection clause in your company’s charter could substantially reduce the number of lawsuits filed challenging an M&A deal and costs associated with defending several lawsuits in multiple jurisdictions.
2. Properly vet and supervise outside advisers
Once a company is contemplating a deal, it can mitigate risks and costs by properly vetting and supervising outside advisers. Recent decisions addressing conflicts of interest highlight the importance of doing so. For example, the Delaware Court of Chancery temporarily enjoined a merger transaction involving Del Monte Foods and certain private equity firms because of conflicts of interest that existed with the investment bank advising on the deal. The investment bank had previously advised Del Monte in connection with various financing transactions. In addition, when Del Monte was not for sale, the investment bank sought unsolicited acquisition interest among various private equity firms that ultimately resulted in bids being presented. The investment bank, however, failed to disclose to Del Monte that it planned to attempt to provide buy-side financing to any successful bidder.
In deciding to enjoin the transaction, the court found, among other things, that the role played by the investment bank impacted the bids considered and the value of the deal. As a result, the court criticized the board’s conduct even though it found the board was misled. The litigation ultimately settled with a payment to shareholders of $89.4 million, $23.7 million of which was paid by the investment bank.
Companies need to ask potential advisers to a deal about their past or current advisory work for potential counterparties to a deal, as well as any lending relationships that exist with counterparties or significant stakeholders in a counterparty. The board also must supervise the work done by advisers to avoid the appearance that they ceded their decision making to advisers.
3. Make sure your special committee is independent, informed and “well-functioning”
Establishing an independent special committee to evaluate a deal is a great start, but in order to withstand scrutiny, the committee should also be informed and “well-functioning.” Courts have found that restrictions placed on a special committee may interfere with its ability to be informed and well-functioning.
For example, if a committee is set up to evaluate a proposed transaction, the resolution creating the committee should also empower the committee to negotiate or investigate alternative transactions. To determine the actual effectiveness of the special committee, courts also may examine the substance of the deal, including how the deal was valued and the scrutiny by the board of any valuations and the methodologies used. As such, it is recommended that committees not be restrained in their mandate. It also is imperative that the committee is free from the perception of conflict, that there are no limitations on the functioning of the committee and that they have the resources necessary to fulfill their mandate.
4. Carefully evaluate the types of disclosures previously subjected to litigation
Claimed inadequate disclosures are at the heart of most M&A shareholder suits. Indeed, most cases ultimately resolve without monetary payments to shareholders in exchange for enhanced disclosures. A recent study by NERA Economic Consulting found that in 87 percent of M&A shareholder cases, plaintiffs’ lawyers are the only ones who were paid any money, while the shareholders in those cases received only enhanced disclosures or modifications of non-monetary deal terms. There is no checklist of disclosures that, if made in a certain manner, will eliminate the risk of litigation. However, prior cases and settlements can serve as a guide to the types and scope of disclosures that companies should consider, including, but not limited to:
- Existing management projections of free cash flow
- Non-standard financial analysis
- Fee arrangements
- The assumptions underlying the valuation analyses, including the basis for comparables, excluded comparables, data for specific comparables and the assumptions underlying discounted cash flow premiums
- Summaries of revised or updated presentations made to the Board regarding valuations or other analyses
- Large shareholder demands for premiums on holdings above and beyond that delivered to other shareholders, whether or not those demands were rejected
- Discussions regarding post-merger employment agreements for management prior to the signing of the merger agreement
Counsel should analyze previously litigated disclosures and consider modeling disclosures based on the enhanced disclosures approved by the court in prior cases. While no court has yet ruled that modeling disclosures on previously accepted enhanced disclosures made by other companies is dispositive, an argument could be made that court approval of disclosure only settlements is a finding of the adequacy of the disclosures, because, in theory, a court could not approve a disclosure-only settlement that includes inadequate disclosures. In any event, using previously enhanced disclosures as models for your next deal, will make it harder for plaintiffs to plead that material information was not disclosed.
Instead of simply pricing the cost of litigation into deals as a form of deal tax, companies should also be proactive in neutralizing the shareholder plaintiffs’ lawyers’ playbook. While there are many considerations beyond those mentioned above that must be taken into account when structuring, evaluating and closing a deal, following these steps could minimize the risk of litigation and reduce the cost of lawsuits that are filed.