What are directors’ duties and what can they do to protect themselves in a sale of company?

The duty of care is a duty to act with reasonable care and to make decisions on an informed, deliberative basis after giving due consideration to relevant information and advice.

To fulfill the duty of care, directors should review all reasonably available, material information regarding a potential transaction and solicit input and advice from management and external advisors when appropriate. Directors should consider the benefits, risks and timing of any proposed sale and any alternative transactions and strategies, including the continuation of the company on a standalone basis. Directors should take sufficient time, to the extent practicable, to consider fully and evaluate a proposed transaction.

The duty of loyalty is a duty to act in good faith and in the honest belief that actions taken and decisions made are in the best interests of the company and its stockholders. To fulfill the duty of loyalty, directors should consider whether there are any conflicts of interest or biases in respect of a potential transaction and, if so, implement procedures to address them.

Conflicts of interest may include, for example, a director standing on both sides of a transaction or a director deriving a personal financial or other benefit from a transaction that is not shared with the stockholders generally, such as an employment arrangement post-merger, ownership of shares in the acquirer and so on.

In recent years, Delaware courts have become significantly more expansive in their views of what would cause a director to be conflicted, including long-standing social relationships between directors, whether a director is appointed by one or more investors to the boards of other companies, etc.

Therefore, a very detailed and candid discussion with counsel at the outset of a transaction about the nature of any such relationships is important to enable the board to follow a process that will reduce the risk of litigation. Transactions involving potential conflicts of interest should be disclosed by the conflicted director, and the other directors should consider appropriate procedures relating to the potential conflict. Such procedures may include the possible negotiation, review or approval of the transaction by the “independent” and “disinterested” directors and/or the approval of the transaction by the stockholders after being fully informed as to all material facts regarding the transaction and any such conflicts.

Under the business judgment rule, courts defer to board decisions made in good faith, on an informed basis and in the honest belief that such decisions are in the best interests of the company and its stockholders. If a court applies the business judgment rule, it will generally uphold board decisions so long as they are attributable to a rational business purpose, and it will not second guess board decisions even if they turn out to be “wrong” when viewed with the benefit of hindsight.

However, in a sale of control of a company, the Revlon standard applies. Under the Revlon standard, the purpose of the board’s duties shifts from long-term corporate planning to short-term value maximization for stockholders, and a court’s standard of review escalates from the deferential business judgment rule to a “reasonableness” standard. In a sale of control of a company, the focus of the board’s duties is to obtain the “best price reasonably obtainable.”

A court will examine the board’s process and deal terms for reasonableness to determine if they assisted the board in obtaining the best value reasonably obtainable. The board may consider factors such as value to stockholders, timing and the likelihood of closing a particular transaction.

Note that there is no single blueprint to satisfy the Revlon standard; the process can range from an auction to a pre-agreement market check or post-agreement market check with modest deal protections, depending on the facts. Board actions that have an anti-takeover effect are also subject to enhanced scrutiny (under Unocal) and will only be upheld if reasonable in relation to the threat posed and if the board’s process was reasonable.

Courts may evaluate the “entire fairness” of a proposed transaction under a much more exacting level of judicial review if the plaintiff can show that the directors breached their duty of care or duty of loyalty. If a court determines to review the “entire fairness” of a transaction, the court will evaluate two components of the transaction:

First, was the board process fair? To answer this question, courts will evaluate all aspects of the transaction process, including timing, negotiation process, disclosures, details of board review, etc.

Second, are the terms of the transaction fair? To answer this question, courts will evaluate all aspects of transaction price, value and terms – often with emphasis on the analyses performed by the company’s financial advisor.

It is important to note that Delaware courts take the view that the fiduciary duties of care and loyalty run primarily to the common stockholders, and that preferred stockholder rights are generally contractual in nature. Preferred stockholders do get the benefit of fiduciary duties when the interests of the preferred stockholders are aligned with the interests of the common stockholders and there are no preferred stock terms that address a specific issue.

This means that directors may at times be required to act in the best interests of the common stockholders (who are viewed by the courts as the residual owners of a company) when the directors have the discretion to do so, even when the common stockholders’ interests are in conflict with those of preferred stockholders. This is true even if a director is appointed by a particular stockholder or class or series of stock. For a summary and analysis of the Trados case, in which the court highlighted these points, please see the following article: https://www.wsgr.com/PDFSearch/survival-guide-2016.pdf.

To protect themselves from liability in connection with a sale of a company, directors should take care to comply with their duties of care and loyalty and to document their consideration of the transaction. In addition, directors should consider the following:

• confirming that the company’s charter contains a limitation of liability clause applicable to directors;
• entering into an indemnification agreement with the company; and
• ensuring that the company has appropriate D&O insurance coverage and purchases a D&O “tail” policy, which is a pre-purchased insurance policy that covers new claims made against directors and officers after the closing that relate to matters prior to closing.

In certain circumstances, it may also be prudent to take the following actions:

• having the transaction approved by an independent committee of directors and/or the stockholders;
• including a ‘fiduciary out” in the acquisition agreement so that the directors can consider a better offer received between signing and closing;
• engaging a banker to identify potential buyers for the company; and/or
• obtaining a fairness opinion from an independent banker.

The law regarding directors’ duties with respect to the sale of a company is complex and is only briefly summarized above. Further, the ideal sales process for any company will depend on that company’s particular circumstances and the details of the transaction being considered. A company contemplating a sale should seek the advice of legal counsel to ensure that the directors are taking appropriate steps to comply with their duties and to protect themselves from liability as they make decisions with respect to the transaction.

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