While corporate directors deciding to sell a company face well-known risk of litigation and enhanced judicial scrutiny, recent cases involving Oracle Corp., Tesla Inc., and New Senior Investment Group Inc. show how directors deciding to buy can also be vulnerable if the deal involves conflicts of interest.
Each of these deals look appropriate to experienced M&A professionals. Each made sense and was supported by an obvious strategic benefit to the acquiring company. The directors in each case relied on the advice of investment bankers and senior management. The only genuine business decision for directors of the target companies was price and all the prices looked okay. But each case also involved a visionary founder who had very substantial economic interest or outright control of both the buyer and the seller.
In all three cases before Delaware Chancery Court, the plaintiffs claim that the deals were orchestrated for the benefit of the founder and accused the directors of breaching their fiduciary duty to maximize shareholder value because of conflicts arising from relationships with the founder or their own interest in the transaction. The chancellors judging the cases found that the management’s loyalty to the founder may have caused them to act unethically, and that the founder was motivated by economic self-interest rather than the good of the company. Rather than using the business judgment rule, which typically protects directors making routine business decisions, he put the burden on the founder or directors of the selling companies to prove the deal’s fairness.
These three cases significantly tilt the playing field in favor of stockholder plaintiffs and place a difficult burden—perhaps unreasonably so—on the buy-side directors and controlling stockholders to prove the deal is fair to the acquiring company. They also clearly show the need for careful structuring and planning by the buy-side board of directors in transactions involving conflict. As a practical matter, companies with powerful founders or controlling stockholders need truly independent directors without significant business or social ties to the founder in order to handle conflict transactions.
Below is a summary of each case, followed by some lessons for protecting acquiring directors and the controlling stakeholder.
New Senior Investment Group
Stockholders of New Senior Investment Group, a publicly traded real-estate investment trust managed by Fortress Investment Group, filed Cumming on behalf of New Senior Investment Group, Inc. v. Edens, No. C.A. No. 13007-VCS, 2018 BL 55724 (Del. Ch. Feb. 20, 2018), against New Senior’s board, alleging the directors inappropriately approved the purchase of a real-estate portfolio from another Fortress-controlled entity, breaching their fiduciary duty.
New Senior, which has no employees of its own and is managed and directed by Fortress-affiliated personnel, owns a portfolio of senior-housing facilities across the U.S. It attempted to buy another Fortress property portfolio from Holiday Acquisition Holdings LLC., the country’s second-largest private owner of independent living communities for seniors, in a deal with clear justification and clear conflicts.
The New Senior board adopted several measures intended to address the conflict of interest: The New South board’s secretary, also Fortress’s general counsel, outlined for the board the process by which it should evaluate the proposed acquisition and answered director questions regarding applicable legal standards. The board formed a transaction committee and delegated to the committee the full authority to consider and accept or reject the deal. That committee retained Greenhill & Co. as its financial adviser and got two financial analyses of the proposed acquisition, including comparable transactions, a discounted cash flow analysis and research analysts’ opinions.
After receiving Greenhill’s fairness opinion, the committee unanimously recommended that the board authorize the acquisition. The board approved the acquisition with both the conflicted founder and conflicted CEO recusing. No stockholder vote was requested.
But there still remained enough conflict of interest among board members that when Vice Chancellor Joseph R. Slights evaluated the case’s motion to dismiss, he found that all of the New Senior directors either had a conflict of interest because they were also Fortress owners and employees, because they financially benefited from financing the transaction, or otherwise had deep personal and financial relationships with Wesley Edens, the co-founder, chairman and largest stockholder of Fortress. Slights found one director was conflicted because she was the executive director of a charity which Edens and his family generously supported. A second director was conflicted because he was a minority owner of a professional basketball team which Edens controlled. A third director, a retired banker, was conflicted because he received a substantial portion of his income from serving on the boards of various Fortress-controlled companies.
Because of the conflicts of interest which allegedly compromised the independence of the New Senior board, Slights applied the entire fairness standard of review to the transaction. In addition, the chancellor found the conflicts raised questions regarding the individual directors’ exercise of their duty of loyalty to the company and therefore they were not protected by the exculpatory charter provisions which would otherwise protect New Senior directors from monetary liability. And he found major process flaws in New Senior’s acquisition including that the New South CEO set its offer price when it was the only remaining bidder and that New South’s financial adviser was hired very late in the process, after the price was agreed. Finally, the members of the transaction committee had relationships with Fortress or Edens which called their independence into question.
Oracle Corp. Stockholder Litigation
In re Oracle Corp. Derivative Litigation, No. C.A. No. 2017-0337-SG, 2018 BL 92432 (Del. Ch. Mar. 19, 2018), involved a lawsuit against Oracle’s board and CEO arising out of Oracle’s acquisition of competitor NetSuite. The transaction involved a conflict of interest because Larry Ellison, the visionary founder and largest stockholder of Oracle also founded and retained a large equity interest in NetSuite.
In 1977, Ellison co-founded Oracle, which became one of the best-known U.S. technology companies, then in 1998, he co-founded NetSuite to provide businesses with internet-based management software. Ellison financed NetSuite at its inception and remained its largest stockholder upon its sale to Oracle, when he and those affiliated with him held about 45% of NetSuite’s outstanding stock.
NetSuite’s success was rooted in its ability to provide cloud-based enterprise resource planning software suites for medium-sized businesses without meaningful competition from large software providers such as Oracle, SAP and Microsoft. But by 2015, Oracle had taken an interest in the middle market and came into competition with NetSuite. NetSuite’s stock price tumbled, falling as low as $53 per share in February 2016 from $107 per share on Jan. 2, 2015.
According to the plaintiff, Oracle’s success in competing with NetSuite posed a problem for Ellison because NetSuite would lose value if Oracle continued to outcompete it. According to the plaintiff, Ellison came up with a solution to have Oracle purchase NetSuite rather than compete NetSuite’s value away.
The Oracle board first learned of the proposal to acquire NetSuite at a retreat held in January 2016 when management provided the board an overview of potential acquisition of NetSuite. The entire board heard this presentation even though, as the stockholder plaintiff points out, Oracle’s independence committee was tasked with reviewing and approving related party transactions and assessing any potential conflicts of interest involving Ellison. Ellison sat in on the meeting, though he did not participate in the discussions.
The Oracle board next met to discuss the potential acquisition two months later without Ellison’s attendance. The board decided to form a three-member special committee, to which it delegated “the full and exclusive power of the board” regarding the potential acquisition. The special committee further received “full powers of the independence committee for purposes of potential NetSuite transaction, including expressly the power to make the required determinations under the independence committee charter and Oracle’s conflict of interest policy.” Finally, the committee was tasked with directing senior management’s involvement in assessing the potential transaction.
The committee hired Moelis & Company, LLC as its financial adviser and retained Skadden Arps as legal counsel.
The committee met without Ellison 13 times over the following months to consider the potential transaction with NetSuite. Moelis and Oracle management gave separate presentations to the special committee, both of which concluded that NetSuite was a preferable acquisition target to other companies. Oracle management stated that after engaging in “careful consideration and review of the potential alternatives, including organic alternatives,” it had come to think that NetSuite offered “the best strategic fit with Oracle.” Moelis for its part, said that NetSuite “would complement Oracle’s ERP offering and provide a number of benefits, including by allowing Oracle to provide a two-tier ERP solution to its customers.”
The price for NetSuite was reached after robust bargaining. The special committee initially offered $100 per share. NetSuite countered at $125 per share. The Oracle special committee responded with $106 per share. NetSuite countered at $120 per share and then $111 per share. Finally the parties settled on $109. Moelis concluded that the acquisition was fair to Oracle.
At the motion to dismiss phase, Vice Chancellor Sam Glasscock found the complaint did not state a claim against Oracle’s eight outside directors. However, he permitted the lawsuit to proceed against Ellison and the Oracle CEO even though both abstained from the vote to approve the transaction. Glasscock stated “a corporate fiduciary who abstains from a vote on a transaction may nevertheless face liability if she played a role in negotiating, structuring or approval of the proposal.”
Glasscock’s opinion makes no mention of the fact that Oracle and NetSuite were locked in a bitter competition to provide cloud-based services to middle market companies. The fact that Oracle was outcompeting NetSuite does not change the fact that the combination of the companies would end the bitter competition where NetSuite otherwise would be expected to cut prices and both NetSuite and Oracle would lose potential profit opportunities. Put another way, the NetSuite acquisition provided huge synergies to Oracle.
There is nothing illegal or unethical in Ellison determining that it would be desirable for both sides if Oracle acquired NetSuite, rather than have a vicious price war that would erode the value of NetSuite. Most knowledgeable M&A professionals would agree that such a transaction would make sense for Oracle, assuming that the right price is right. There is no basis whatsoever to believe that Ellison directly or indirectly sought to influence or control the price determined by the special committee.
Tesla Motors Stockholder Litigation
In re Tesla Motors, Inc. Stockholder Litigation, No. Consolidated C.A. No. 12711-VCS, 2018 BL 107252, (Del. Ch. March 28, 2018), involved a stockholder lawsuit against the board of Tesla Motors arising from Tesla’s acquisition of SolarCity Corp., a solar-energy system installer. Elon Musk was a substantial stockholder of both companies and influential in both companies’ management.
The plaintiff’s complaint alleges that the acquisition was a bailout out of SolarCity that benefited six of the seven members of the Tesla board. The lawsuit claims that Musk, as Tesla’s controlling stockholder, breached his fiduciary duty for using his control over the corporate machinery to orchestrate board approval of the acquisition. The lawsuit also asserts a claim against the other directors for causing Tesla to enter into a self-dealing acquisition.
Tesla manufactures and sells electric vehicles and energy storage products. Musk, the company’s largest stockholder, owns about 22 percent of the common stock. Tesla’s seven-member board included Musk, his brother and five other directors, all of whom either had substantial investments in SolarCity, were highly compensated by Tesla or were otherwise alleged to be close friends of Musk. According to Slights’ opinion, the facts viewed most favorably to the stockholder plaintiffs suggest that none of the Tesla directors were truly independent of Musk and SolarCity.
SolarCity, which leases solar panel equipment to residential and commercial customers, was co-founded by Musk, who was SolarCity’s chairman and largest stockholder, holding about 22 percent of the common stock. The company’s primary source of revenue is lease payments received from customers. In 2016 SolarCity faced a liquidity crisis because its existing loans were maturing and it had exhausted its ability to borrow more money or sell more stock. The shares had dropped by about two-thirds in 2015.
At three separate Tesla board meetings during the summer of 2016, Musk proposed that Tesla acquire SolarCity. Musk argued that the combination would complement the company’s energy business, grow the Tesla sales operations and create other products, services and operational synergies.
At the third meeting the Tesla board authorized Musk and management to assess the potential acquisition and to engage an independent financial adviser and counsel to review the potential acquisition. Musk, as CEO, retained Wachtell Lipton as legal adviser and Evercore Partners as a financial adviser to advise both Tesla’s board and Tesla’s management. The Tesla board did not form a special committee to consider the acquisition despite certain Tesla board members’ obvious conflicts of interest.
Twenty days later, the Tesla board called a special meeting to further explore the acquisition. Musk reviewed the strategic considerations for acquiring SolarCity. The board authorized an offer for SolarCity.
Musk and a second director who also served on the SolarCity board recused themselves from the meeting while the remaining members of the board voted to approve the offer for SolarCity. But both remained for the entirety of the meeting while the potential acquisition of SolarCity was discussed, and Musk led most of those discussions. When the time came for the vote, the board approved and adopted the offer on the same terms discussed when the two directors were present.
The merger agreement required an approval of the Tesla stockholders even though the vote was not required by Delaware law. The merger agreement excluded Tesla stockholders who were also directors or executive officers of SolarCity from voting. Of the 118 million shares of Tesla common stock eligible to vote, 69 million or 58 percent voted in favor of the acquisition. As a result of the acquisition, Tesla’s debt load nearly doubled.
According to the plaintiff’s allegations, there were practically no steps taken to separate Musk from the board’s consideration of the acquisition. He brought the proposal to the board three times. He then led the board’s discussions regarding the acquisition and was responsible for engaging the board’s advisers. According to the complaint, the board never considered forming a committee of disinterested independent directors to consider the acquisition. The board took that role upon itself, notwithstanding the obvious conflicts of its members.
Slights denied the defendants’ motion to dismiss, finding that it was reasonably conceivable that Musk controlled the Tesla board in connection with the acquisition. He also held that the disinterested stockholder approval did not justify business judgement review of the plaintiff’s breach of fiduciary duty claim, because Musk may reasonably be deemed a controlling stockholder. Instead, all the defendants would be subject to review under the entire fairness standard.
Slights’ opinion ignores the extremely close association between Tesla, SolarCity and Musk in the minds of investors. The two companies are integrated in the same endeavor. Tesla makes electric cars and energy storage products. SolarCity helps homeowners convert solar energy to the electricity necessary to run the electric cars. Both companies are closely identified with Musk and his vision for the future.
A Tesla director, acting as a reasonably prudent business person, would realize that the collapse of SolarCity would likely shake the investing public’s confidence in Tesla. In other words, the collapse of SolarCity would not have been an isolated event, but rather hurt Tesla’s ability to continue raising large amounts of capital to fund Musk’s vision. Slights is however, totally silent regarding this extremely valid reason for the deal. Presumably Musk and the directors will make this argument at trial.
Lessons for Protecting Buy-Side Directors and the Controlling Stockholder
These three recent cases demonstrate the need for buy-side directors to approach conflict M&A transactions with extreme caution.
In order to reduce the risk, the board should contain a majority of directors who are unquestionably independent of the controlling stockholder. Independence exists if a director’s decision is based on the corporate merits of the subject before the board rather than on extraneous conditions or influences. The board should condition discussions of a conflict acquisition up-front on both the negotiation and approval of an empowered independent committee and a majority-of-the-minority stockholder vote.
Directors lack independence when they are beholden to the controlling stockholder or so much under his or her influence that their objectivity could be compromised. In these three cases, directors were held not to be independent because they relied on the controlling stockholder or the company for valuable business relationships or for meaningful compensation.
The Board should also adopt a process at the outset of discussions based on the procedure approved by the Delaware Supreme Court for controlling stockholder buy-outs in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014). If the board adopts all of these safeguards, the director’s approval of a conflict M&A deal should be reviewed by the court under the more deferential business judgment rule standard, rather than an entire fairness standard of review. In that case, the claims against the defendant directors and controlling stockholder must be dismissed if a rational person could have believed that the acquisition was favorable to the minority stockholders.
Under M&F Worldwide, the business judgment standard of review will be applied if:
- The Board conditions the procession of the conflict M&A acquisition on the approval of both a special committee and a majority of the minority stockholders;
- The special committee is independent;
- The special committee is empowered to freely select its own advisers and to say no definitively;
- The special committee meets its duty of care in negotiating a fair price;
- The vote of the minority is informed; and
- There is no coercion of the minority stockholders.
Gardner Davis is a partner in Foley & Lardner LLP’s Transactional & Securities, Bankruptcy & Business Reorganizations, and Private Equity & Venture Capital Practices. He advises boards of directors and special committees in regard to fiduciary duty issues in various contexts, and he has extensive experience restructuring financially distressed enterprises, both inside and outside of bankruptcy.
John Wolfel is a partner in Foley & Lardner LLP’s Transactional & Securities Practice. His practice is focused on corporate and securities laws matters, including mergers and acquisitions and securities law compliance counseling. Mr. Wolfel has worked on public and private offerings, represented public companies in connection with their periodic reporting to the Securities and Exchange Commission and worked on business combinations for public and private companies.