The role of the Board and Board conduct in relation to change of control and other strategic transactions is a key focus of regulators and investors and has been the subject of much recent comment, including in the recently released decision of the Ontario Securities Commission (OSC) concerning the HBC going private transaction.
In the context of such transactions, enhanced disclosure requirements apply and both regulators and investors, including activists, will review the disclosure critically, zeroing in on those aspects of the Board’s process and decision-making that are most sensitive. As the HBC experience illustrates, if a transaction is contested by stakeholders, that scrutiny can be particularly intense and involve second-guessing from hindsight. Boards should therefore conduct themselves with a view to ensuring their decision-making can withstand such scrutiny, protecting against legal and reputational risk.
The key theme that runs through regulatory and other commentary is that Board decision-making in this context must be unconflicted and fully informed, which are two key factors in determining the degree of deference that will be given to directors’ decisions.
Unconflicted decision making
Respective roles of directors and management: The Board has an enhanced oversight role in the context of material transactions because of the significance of such transactions for the company and the potential for management to be conflicted due to the implications of the transaction for them personally. It is appropriate and necessary for management to be very involved in the process, but the process must be led by the Board (or a committee of the Board, as discussed below) and a portion of the process must necessarily be conducted independently of management.
Director conflicts and the use of a special committee: The Board must consider, as a threshold matter, whether a potential transaction presents any conflicts of interest for directors. Conflicts can be addressed through the recusal of conflicted directors from decision-making concerning the transaction or by forming a special committee of independent directors to deal with the transaction.
Securities laws require a special committee in limited prescribed circumstances. However, special committees are regularly established, even where not legally required, both to address director conflicts and to facilitate oversight and decision-making. In the HBC decision, the OSC emphasized that where the Board, in presenting a transaction to investors, is relying on the fact that the process involved a special committee, the special committee will be held to the same standard, whether or not the special committee was legally required:
If a special committee is employed, the disclosures related to its process will be open to the same scrutiny as if its establishment was mandated, whether it was formed as a result of corporate law considerations, securities law requirements, and best practices, or as a perceived necessary step to gain shareholder approval in a conflicted transaction.
Where there are conflicts to be addressed, they need to be dealt with at the outset. In HBC, the special committee was established to deal only with the going private transaction and not previously approved divestiture transactions that it turned out were integral to the going private transaction because they provided necessary funding. The OSC commented:
Given that the [previously approved divestiture transactions] were interrelated with Baker’s privatization proposal in that they were intended to be a source of funding, and given that conflicts of interest arose from that fact alone, prudence would dictate that a special committee would be in place to address all of these transactions and their interrelationships at this early stage. We question whether the absence of a special committee at this time compromised the Special Committee’s later effectiveness…
Where a special committee is established, the Board retains general oversight responsibility. However, the Board should normally defer to special committee recommendations. Indeed, in most circumstances, a special committee’s approval should be required for the transaction to proceed. Second-guessing by the Board is inconsistent with the premise behind the use of a special committee as a means to address director conflicts or to enable a subset of the Board to be more fully informed through more intensive engagement than would be possible for the Board as a whole.
Adviser conflicts: The Board must satisfy itself, not only that the directors responsible for overseeing the transaction are unconflicted, but that the advice from legal and financial advisers they are receiving and relying on is free from any undue pressure arising from pre-existing relationships or fee structures. Accordingly, the Board must diligence potential conflicts of its financial and legal advisers. Conflicts could arise based on relationships of the advisers with management or other parties to the transaction, or from the structure of adviser fee arrangements. Warren Buffet has commented in this connection on “the many advisers and other professionals who feast on deals” and has cautioned, “Don’t ask the barber whether you need a haircut.”
Fully informed decision making
Appropriate mandate for Board or special committee: In considering a transaction, the directors—whether the full Board or a special committee–must have a broad mandate to consider the transaction and all available alternatives, including the status quo. Any constraints on their mandate will be viewed by regulators and investors as undermining the decision-making process, will attract second-guessing and may ultimately put the transaction at risk. The OSC, drawing on securities regulatory jurisprudence, has summarized its expectations with respect to the mandates of special committees as follows:
We generally expect that a special committee mandate will include the ability to do the following: (a) either negotiate or supervise the negotiation of a proposed transaction, rather than simply review and consider it, (b) consider alternatives to the proposed transaction that may be available, including maintaining the status quo or seeking other transactions that would enhance value to minority security holders, (c) make a recommendation regarding the proposed transaction, or, if it does not, provide detailed reasons why not, and (d) hire its own independent legal and financial advisors, without any involvement of, or interference from, interested parties or their representatives.
Leveraging advice: For director decision-making to be fully informed, it has to take advantage of all material information reasonably available in the circumstances. This requires that the directors get appropriate independent expert advice. For this purpose, there are three key considerations:
- The advice must be timely so that the directors have it before any material steps are taken.
- The advisers must be unconflicted, as discussed above.
- The advisers must not be constrained in their evaluation of the matters under consideration, whether through a mandate that is too narrow, or a lack of information or access to the required resources. In HBC, the OSC concluded that the independent valuation of the going private transaction proposal was compromised by constraints imposed on the mandate of an appraiser whose work was a critical input for the valuation.
Independent advisers advising boards need to recognize their own responsibility to be proactive and assertive, recognizing that the directors are not themselves necessarily experts in M&A or aware of market practice, do not necessarily know all of the right questions to ask, and are relying on their advisers’ expertise and experience to guide them.
Understanding alternatives: It is critical that directors not only canvass all available alternatives pursuant to an appropriately broad mandate, but that they understand the implications of the various alternatives for all affected stakeholders and factor those implications appropriately into their assessment of the merits of the transaction and their disclosure to investors. In HBC, the tax structure had particular benefits for the continuing shareholders as compared with retail investors. The disclosure did not explain the special committee’s thinking on the value differential as between those shareholder groups and why it was appropriate but merely indicated that shareholders may prefer to sell into the market prior to completion of the transaction. The OSC ordered enhanced disclosure on this point and commented:
In a business combination subject to MI 61-101, there is the ever-present risk that the conflict of interest, to which the management-led continuing shareholders are subject, may result in their interests being favoured in the structuring of the transaction. A special committee, in negotiating or supervising the negotiation of such a transaction, must be alert to all factors affecting value, including tax structuring…To the extent that the tax structure benefits the Continuing Shareholders, and the Special Committee believes it was necessary or appropriate for this benefit to be conferred on them, the Circular should include an explanation.
Understanding tactical implications of process decisions: Decisions with respect to process can have significant substantive implications for both the range of alternatives that are available and negotiating leverage. Fully informed decision-making requires that the directors fully understand these implications with the benefit of independent advice before any material steps are taken.
In the HBC case, the OSC was critical of a number of process decisions made at the outset that it concluded had compromised the process by limiting the range of options available to the committee and the committee’s leverage. This was aggravated in that case by the fact the decisions were made by the lead director before the special committee was established and independent advisers were in place. Those decisions included: granting third parties access to company information, waiver of a standstill that prevented a current shareholder from being party to a going private transaction, and a conflict waiver permitting company counsel to act for the proponents of the going private transaction.
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