June 20 2012
Lessons for boards of directors today
A recent Delaware Chancery Court decision acts as another reminder of the risks to deal consummation posed by serious conflicts of interest of management and financial advisers, as well as the critical role played by a board of directors in managing such conflicts of interest.
In Re El Paso Corporation Shareholder Litigation(1) addressed the conflicts arising in the sale of publicly held corporation El Paso Corporation to Kinder Morgan.
Chancellor Strine noted a number of conflicts of interest raised by this transaction, including:
Strine noted that the record showed a number of debatable negotiating and tactical decisions which nonetheless, in the absence of a conflict of interest, would not have raised concerns. Given that the CEO and Goldman Sachs, the board's long-time and trusted financial adviser, had serious conflicts of interest, the decisions by the CEO and Goldman Sachs were viewed as potentially "compromised by the conflicting financial incentives of these key players".
Although Strine declined to grant a preliminary injunction, he found that the plaintiffs had a reasonable likelihood of success on the merits in proving a breach of the loyalty duty, thus potentially exposing the defendants to claims for damages post-closing. The decision not to enjoin was based on the chancellor's conclusion that the stockholders had a choice to turn down the merger and his unwillingness to remove a premium bid from the stockholders, given that no alternative bid existed.
The record provided some examples of the types of decision made by the negotiators, which were subject to serious second-guessing in light of the CEO and Goldman Sachs conflicts:
If a board entrusts a CEO as sole or key negotiator for a merger deal, that CEO's reasonably anticipated potential conflicts of interest must be carefully considered. Inquiries as to such conflicts should take place at the beginning of the deal negotiations. Management is virtually certain to have conflicts arising in any sale of control, resulting from its employment status or agreements governing compensation in a change of control. In the case at hand, beyond those employment-related conflicts, the board apparently never asked the CEO if he was interested in buying the spun-out E&P business, although it seems reasonably anticipated that management would have had some interest in taking over that business.
To address the conflicts of interest, the board could have interposed a Morgan Stanley banker or an independent director or committee to review the proposed deal and the full range of strategic and tactical decisions in the negotiations, such as the appropriate response to Kinder Morgan's puzzling reduction of its initial preemptive proposal. Goldman encouraged the El Paso board to avoid a hostile situation with Kinder Morgan; however, not only did Goldman have conflicts, but the CEO also had undisclosed incentives not to negotiate the highest price for El Paso, including his interest in leading a management buyout of the E&P business. An independent board or banker could have pushed harder to consider alternative strategies.
If a conflict of interest with a trusted bank adviser arises and a second bank is engaged, the board's attention and allegiance should shift to the second, unconflicted bank; the board should negotiate engagement terms that provide incentives for unconflicted advice. In this case, the board could have attempted to negotiate away Goldman's exclusivity, paid Morgan Stanley a fee if the spinoff transaction was chosen or could have agreed to pay a flat advisory fee credited against the transaction fee if the sale to Kinder Morgan was the alternative chosen.
If a bank has a conflict of interest causing it to favour a particular transaction, the board should view the bank's advice about alternatives to such a deal with scepticism. Thus, the advice that Goldman gave about the value of the spinout to El Paso stockholders had to be judged in light of what Goldman stood to gain if the Kinder Morgan deal was chosen.
It would be prudent to ask banks about individual banker conflicts. In the case at hand, the Goldman banker likely would have disclosed his personal interest in Kinder Morgan had he been asked.
Deal lock-ups should be negotiated with an eye to the most likely alternative transactions. Although the formulation of the definition of superior proposal was not 'off market' in requiring a proposal for a majority of the stock or assets of the company to be the subject of such proposal, the alternative actively being considered by the El Paso board was a spinoff of slightly less than 50% of the El Paso business. It made little sense to prohibit El Paso from talking to bidders about a deal for the E&P business, as that was the most likely alternative transaction to be considered by the El Paso board.
The El Paso decision, while not resulting in an injunction, provides useful lessons for boards of directors dealing with conflicts of interest.
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