In re Comverge: Chancery Court Rejects Motion to Dismiss Revlon Claim on Basis of 5.55% Break-up Fee Alone

Practical Law Legal Update 2-591-2605 (Approx. 12 pages)

In re Comverge: Chancery Court Rejects Motion to Dismiss Revlon Claim on Basis of 5.55% Break-up Fee Alone

by Practical Law Corporate & Securities

Background

The case arises from private equity firm HIG Capital's acquisition of Comverge, Inc. in early 2012. Comverge's shares debuted for trading on the NASDAQ in April 2007 at an IPO price of $18.00 per share, but had fallen to $1.88 per share by the day before the announcement of Comverge's deal with HIG.

In the years leading up to the merger agreement with HIG, Comverge had been suffering substantial losses, which created a serious need for additional capital. To meet this need, Comverge entered into two credit facilities:

An amended revolver with Silicon Valley Bank for $30 million.
An agreement with Partners for Growth III, L.P. for $15 million in convertible notes (the "PFG Note"). The PFG Note required Comverge to meet certain minimum capitalization requirements, and gave the noteholder the right to block any acquisition proposal for Comverge.

Beginning in 2011, Comverge began considering various alternatives for meeting its capital needs, including public equity offerings, issuing new debt and direct sales of equity stakes. None of these options panned out. Later in 2011, HIG contacted Comverge about a potential investment, and the parties began discussions. In November of that year, HIG and Comverge signed a non-disclosure agreement that contained a two-year standstill provision. The standstill prohibited any acquisition of Comverge securities or other securities convertible into Comverge securities. However, the NDA contained an exception that permitted HIG to acquire any securities of Comverge "in the public markets as a public investor in Comverge."

Later that year, HIG submitted a non-binding proposal to acquire Comverge at $1.75 per share and to make a $12 million bridge loan to the company. HIG also requested a 30-day exclusivity right to negotiate with Comverge. The board of Comverge formed a special committee, which met to discuss the offer and declined to grant exclusivity to HIG. After HIG twice raised its bid, first to $2.00 and then to $2.15 per share, the committee agreed to grant HIG exclusivity for a 20-day period. Two days after the grant of exclusivity, a third party emerged and indicated that it would be prepared to offer Comverge between $4.00 and $6.00 per share. Comverge, however, could not engage with that bidder because of its exclusivity agreement with HIG. Instead, the committee pressed HIG to raise its bid, which it did, to $2.25 per share. When the board, on the advice of its financial advisor, continued to deem HIG's offer inadequate, HIG declined to raise it again and allowed its offer, and the exclusivity period, to lapse on February 15, 2012. The board turned its attention to the third-party bidder, but nothing came of those discussions. All the while, Comverge's financial situation only worsened, forcing the board to consider a debt restructuring and to also contend with a potential proxy contest from a major stockholder.

HIG Applies Pressure

To take advantage of Comverge's situation and distractions, HIG, through an affiliate, bought the PFG Note at a 10% premium to its face value. The board considered taking legal action against HIG for possibly violating the terms of its standstill, but ultimately decided against it. The explanation offered by the board was that given the company's severe liquidity concerns, it could not justify the costs of litigation when weighed against the uncertainty of success. In addition, HIG still remained a viable and perhaps sole bidder for Comverge, whom the company could not afford to push away. The board determined that it would be better off leveraging the situation toward a strong go-shop provision in a merger agreement with HIG, rather than suing HIG.

With the risk of litigation out of the way, HIG applied pressure on the board, notifying it that Comverge was in default for failing to deliver certain compliance certifications and failing to meet required revenue targets. HIG offered in return to acquire the company, but at a reduced price of $1.50 per share and with a lower reverse break-up fee than had originally been offered ($3.5 million instead of $20 million). HIG continued to offer a bridge loan as well, though the loan contemplated notes that would be convertible into Comverge common stock at $1.40 per share.

The Comverge board tried to find other solutions, such as equity-financing transactions from existing stockholders. But no practicable solution materialized because of the uncertainty over Comverge's debt, and the company's auditor opined that there was substantial doubt as to Comverge's ability to continue as a going concern.

With Comverge's stock trading at $1.88 per share, the special committee asked HIG for its best and final offer. HIG raised its bid to $1.75 per share, but also threatened that it would accelerate the debt under the PFG Note if a merger agreement were not signed within two days. The committee received a fairness opinion from its financial advisor and the company went on to sign a merger agreement with HIG. The parties also entered into a $12 million bridge loan agreement, which HIG funded immediately.

The Merger Agreement and Aftermath

The merger agreement contemplated a front-end tender offer structure with a top-up option to reach the ownership threshold for the second-step merger (this being before the passage of Section 251(h) of the DGCL). The agreement contained a 30-day go-shop with a 10-day extension to continue negotiations over potentially superior proposals. The agreement also contained a two-tier break-up fee, by which:

Comverge would pay HIG $1.206 million, and reimburse up to $1.5 million of HIG's expenses, for terminating the merger agreement during the go-shop period. Assuming full payment of expenses, the total payable to HIG would amount to 5.55% of the deal's equity value and 5.2% of its enterprise value.
The $1.206 million fee would rise to $1.93 million after the go-shop period. Assuming full payment of expenses, the total payable to HIG would amount to 7% of the deal's equity value and 6.6% of its enterprise value.

After the announcement of the merger agreement, Comverge's largest stockholder disclosed a letter addressed to the board in which it severely criticized the merger. In the letter, the stockholder not only took issue with the transaction's value, but with the size of the potential break-up fee payments. It pointed out that HIG stood to make a profit of $3 million or more by converting the bridge loan notes into common stock (which were "in the money" at $1.40 per share). Seen in that light, Comverge's total termination payments could pass $5.7 million during the go-shop period and $6.43 million afterward, amounting to 11.6% and 13.1%, respectively, of the equity value of the transaction.

During the go-shop period, Comverge's financial advisor contacted multiple potential buyers, some of whom signed NDAs and conducted due diligence. Two bidders made tentative indications of interest, but no firm bid emerged. By May 14, 2012, 65.1% of the Comverge common shares had been tendered, at which point HIG exercised its top-up option. The merger closed on May 15, 2012.

Revlon and Aiding and Abetting Claims

The plaintiff stockholders' complaint alleged two primary counts:

That the board of Comverge breached its fiduciary duties by failing to take reasonable steps to maximize the value of the company.
That HIG aided and abetted the director defendants' fiduciary breaches since the breaches could not have occurred but for HIG's conduct and knowing participation in those breaches.

The plaintiffs' Revlon claim against the directors specifically alleged that the board had:

Failed to properly inform itself before deciding not to sue HIG for breaching the NDA when it bought the PFG Note.
Unreasonably entered into the exclusivity agreement with HIG.
Conducted a flawed sale process that had resulted in a grossly inadequate merger price of $1.75 per share.
Agreed to deal protections—in particular, the break-up fee, expense reimbursement and convertible notes—that were preclusive of any potential topping bids.

The director defendants moved to dismiss, arguing that any potential breaches of the duty of care they may have committed would be exculpated by the company's Section 102(b)(7) provision. The plaintiffs countered that the directors' conduct amounted to bad faith and was not protected by the exculpation provision.

To the claim of aiding and abetting, HIG in its motion to dismiss responded that the board had committed no breach of the duty of care that could form the basis of an aiding and abetting claim, and that even if the board had breached the duty of care, the plaintiffs had not established a reasonable inference that HIG had knowingly participated in it. The plaintiffs countered that the facts as alleged were enough to establish knowing participation, and that, reminiscent of Rural/Metro, even if the directors were exculpated for their breaches, HIG could still be held liable for aiding and abetting those breaches (In re Rural Metro Corp. S'holders Litig., 88 A.3d 54, 99-103 (Del. Ch. 2014)).

Outcome

The Court dismissed the plaintiffs' Revlon claim against the board with respect to the allegations related to the pre-signing sale process. But the Court held that the termination payments were conceivably unreasonable beyond the point of exculpation and therefore denied the motion to dismiss regarding that allegation.

The Court granted HIG's motion to dismiss the aiding and abetting claim, holding that even though the directors had conceivably acted in bad faith, HIG had not knowingly participated in that breach as a matter of law.

The Board's Motives Were Proper

In reaching its decision, the Court first described the familiar Revlon standard of review applicable to changes of control, which is an intermediate standard of enhanced scrutiny that seeks reasonableness on the part of the directors in their pursuit of maximum value for the stockholders. In that regard, the Court laid out the bifurcated formulation from QVC, in which the Delaware Supreme Court explained that the key features of the enhanced scrutiny test are an examination of:

The adequacy of the decision-making process employed by the directors, including the information on which the directors based their decision.
The reasonableness of the directors' action in light of the circumstances then existing.

(Paramount Commc'ns Inc. v. QVC Network Inc., 637 A.2d 34, 45 (Del. 1994).)

The Court here, somewhat tersely, interpreted this formulation as comprising the "subjective and objective components" of enhanced scrutiny. Other Court of Chancery cases cited by the Comverge court that have begun their analysis with the QVC formulation have given this point more detailed treatment. For example, in Dollar Thrifty, the Court explained that a benefit of reasonableness review is that "it mandates that the court look closely at the motivations of the board" (In re Dollar Thrifty S'holder Litig., 14 A.3d 573, 598 (Del. Ch. 2010)). As the Dollar Thrifty decision went on to describe, when the board is entitled to the presumptions of the business judgment rule, the rule applies because the board is disinterested and thus has no apparent motive to do anything other than act in the best interests of the corporation and its stockholders. By contrast, where heightened scrutiny applies, the predicate question of what the board's true motivation was comes into play. The court then must question whether personal interests short of pure self-dealing have influenced the board to block a bid or to steer a deal to one bidder rather than another. By examining the board's conduct along these lines, the court seeks to "smoke out mere pretextual justifications for improperly motivated decisions."

The Court here determined that the board's motives were not in question. Only one director out of ten was not independent and the plaintiffs had not raised any doubt as to the independence and disinterestedness of the other nine. The directors also collectively owned over 900,000 shares of Comverge stock, which aligned their interests with those of the public stockholders.

Having found that the board was not improperly motivated, the Court turned to the objective reasonableness of the board's decisions. Here the Court emphasized the warning in QVC that the Court must apply enhanced scrutiny to decide "whether the board made a reasonable decision, not a perfect decision" (637 A.2d at 45).

Process Claims Dismissed

Based on a standard of reasonableness but not perfection, the Court dismissed the plaintiffs' claims based on the NDA, exclusivity agreement and overall process.

The Court acknowledged that the timing of the entry into the exclusivity agreement may have been unfortunate in hindsight because it blocked the board from pursuing negotiations with a third-party bidder when the opportunity presented itself. But that missed opportunity could not form the basis for a successful Revlon claim. The record showed that the board had initially pushed back against exclusivity with HIG and ultimately agreed to a shorter period than HIG wanted. The Court held that the board had reasonably determined that it should grant exclusivity in return for further negotiating HIG's offer, which at that point was more firm than any expression of interest that might come forward during the 20-day exclusivity period.

The board's decision not to sue HIG for possibly breaching the standstill agreement by buying the PFG Note was also found reasonable. The board at the time of its decision was in active pursuit of strategic transactions for the sake of salvaging the company as a going concern. In that context, the board reached a reasonable decision that it was better off pushing hard for an effective go-shop with HIG than suing HIG, the only firm bidder at the time. The Court also considered it sufficient that a "non-frivolous" argument could be made that HIG had not breached the standstill, depending on whether the PFG Note qualified as a "security" under the NDA and whether the exception in the NDA for public investments applied to the purchase of the PFG Note. Given these arguments in a hypothetical breach of contract suit, the board could be given the benefit of the doubt that the costs of bringing a claim against HIG did not justify the risk of losing on that claim.

The Inadequate Price Claim

The Court considered the claim that the board had failed to obtain the highest price reasonably available to be a closer call. The $1.75 per share merger price was a discount to the unaffected market price of $1.88 per share the day before and far below the 52-week high of $5.09 per share. The board itself had rejected a $2.25 per share offer from HIG as too low. On those facts, the Court held that it was reasonably conceivable for purposes of a motion to dismiss that the board had breached its duty of care.

However, the Court held that even if the board had breached its duty of care by agreeing to a $1.75 per share merger price, that decision would be exculpated by the company's Section 102(b)(7) exculpation provision. For a board decision to be so extreme as to overcome the exculpation provision, it must implicate the duty of loyalty or have been made in bad faith. Bad faith can be established in several ways, including if the board:

Intentionally failed to act in the face of a known duty to act, demonstrating a conscious disregard of its duties.
Acted in knowing violation of a law.
Acted for any purpose other than advancing the best interests of the corporation or its stockholders.

(In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 67 (Del. 2006); see also Practice Note, Fiduciary Duties of the Board of Directors: Duty of Good Faith.)

In Revlon claims, the plaintiff usually asserts that the board intentionally failed to satisfy its Revlon duties. The standard for this allegation is to demonstrate that the board "utterly failed to attempt to obtain the best price" (Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 244 (Del. 2009)).

Here, whatever the failures of the Comverge board to obtain the best price that might have been available, the board could not be said to have utterly failed to have even attempted to obtain that price. The board engaged in an 18-month long strategic process during which it:

Formed a special committee of disinterested and independent directors.
Hired financial and legal advisors.
Widely canvassed the market for potential bidders.
Considered alternatives to a sale of the company, including an equity infusion and a debt restructuring.
Obtained a fairness opinion.
Negotiated for a price increase from $1.50 per share and for a go-shop.

Although the board allowed itself to be outmaneuvered when HIG bought the PFG Note, it was still highly engaged throughout the process and could not be said to have acted in bad faith.

Break-up Fee Claim Survives Motion to Dismiss

In spite of its dismissal of the general process claim against the board, the Court held that the claim that the board had acted unreasonably by agreeing to preclusive deal protections could conceivably overcome the 102(b)(7) exculpation provision and must survive a motion to dismiss.

The Court said that a fee and expense reimbursement of 5.55%—the lowest amount under the merger agreement that Comverge would have to pay to accept a superior offer—would "test the limits" of what the Court has considered a reasonable range for break-up fees. The Court cited in particular the Answers decision, which called a 4.4% fee "near the upper end of a 'conventionally accepted' range," and Topps, which called a 4.3% fee "a bit high in percentage terms" (see In re Answers Corp. S'holders Litig., , at *9 (Del. Ch. Apr. 11, 2011) and In re Topps Co. S'holders Litig., 926 A.2d 58, 86 (Del. Ch. 2007)). (The Court mentioned in a footnote that the enterprise value is sometimes considered the more appropriate metric for measuring the percentage amount of the fee, but said that the enterprise value and equity value were similar enough here that it did not have to choose between them.)

The Court also agreed with the plaintiffs for purposes of a motion to dismiss that HIG's conversion privilege should be weighed together with the amount of the break-up fee itself. Because the notes under the bridge loan were convertible at $1.40 per share, an offer superior to $1.75 per share by even one penny would mean a profit to HIG of 36 cents per share. With 8,571,428 shares of Comverge common stock convertible through the bridge loan, HIG would be entitled to a $3.085 million payment if it so chose. That payment, together with the break-up fee and expenses, would amount to 11.6% of the equity value of the transaction, even if the agreement were terminated during the go-shop period. This amount, at more than double the upper bound of the traditional range of reasonableness for break-up fees, was high enough for the Court to consider it reasonably conceivable that the board's acceptance of it amounted to bad faith as a matter of law.

The defendant directors argued that the Court should not consider the conversion feature alongside the break-up fee and that in any event the company was so badly in need of liquidity that the agreement to the conversion feature was reasonable under the circumstances. However, the Court held that at the motion-to-dismiss stage, the total payments should be found unreasonable. To reach that conclusion, the Court reviewed the facts and circumstances described in Crawford for evaluating a break-up fee, including:

The overall size of the fee.
Its percentage value.
The benefit to stockholders of having a break-up fee in the agreement, including a premium (if any) that the directors seek to protect.
The absolute size of the transaction.
The relative size of the partners to the merger.
The degree to which a counterparty found the fee to be crucial to the deal, bearing in mind differences in bargaining power.
The preclusive or coercive power of all deal protections included in the transaction, taken as a whole.

(La. Mun. Police Employees' Ret. Sys. v. Crawford, 918 A.2d 1172, 1181 n.10 (Del. Ch. 2007).)

The Court held that the Crawford factors weighed against a finding of reasonableness and even good faith at a preliminary stage. The Court highlighted in particular:

The large size and percentage of the total payments, especially when considering the conversion feature.
The fact that the deal contemplated a negative premium to the market price.
The parties' relative bargaining power, by which it appeared that the board gave HIG whatever it wanted without pushing back meaningfully on the break-up fee payments.

In the Court's view, the board's passive acceptance of the fee terms was "so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith" (In re Alloy, Inc. S'holders Litig., , at *10 (Del. Ch. Oct. 13, 2011)).

Aiding and Abetting Claim Dismissed

HIG moved to dismiss the claim against it on the grounds that the directors themselves had not committed any non-exculpated breach, and that even if they did, HIG had not aided and abetted it. Because the Court found for purposes of the director defendants' motion that they had conceivably acted in bad faith by agreeing to unreasonably high termination payments, the Court analyzed whether HIG had knowingly participated in that particular decision of the board.

The Court first discussed the standard for a finding of knowing participation and noted that a party does not have to have subjective complicity with the fiduciary to be found to have aided and abetted the breach of a duty. Rather, it is enough if the third party, for its own improper motives, misleads the directors into breaching their duty, such as when:

Self-interested officers of a target company steer the board toward a favored private equity buyer, at the stockholders' expense (Mills Acq. Co. v. Macmillan, Inc., 559 A.2d 1261, 1283-84 (Del. 1989)).
A buyer conspires with a conflicted financial advisor (In re Del Monte Foods Co. S‟holders Litig., 25 A.3d 813, 837 (Del. Ch. 2011)).
A financial advisor creates the board's unreasonable process and informational gaps that led to the board's breach of duty (Rural/Metro, 88 A.3d at 99)).

These examples, the Court explained, stand in contrast to cases where there was no abuse of trust by the third party toward the corporate fiduciaries. Particularly when the accused third party is a buyer, the Court commonly holds that a bidder's attempts to reduce the sale price through arm's-length negotiations cannot give rise to liability for aiding and abetting, so long as the bidder does not induce the target's fiduciaries to agree to a bad deal for the target's stockholders by creating or exploiting the fiduciaries' self-interest. The Court recognizes that in a negotiation over a merger, each side attempts to strike the best deal it can for its own stakeholders. The fact that a buyer got "too good a deal" does not support a claim of aiding and abetting.

Here, the Court held that HIG had not crossed the line by exploiting a conflict of interest on the part of the board. It had simply negotiated the best possible deal for itself. The Court therefore dismissed the claim against HIG.

Practical Implications

As explained at length in Practice Note, Break-up or Termination Fees: Size of the Break-up Fee, there is no bright-line rule under Delaware law for an acceptable size of the fee. Rather, "the reasonableness of such a fee depends on the particular facts surrounding the transaction" (In re Cogent, Inc. S'holder Litig., 7 A.3d 487, 503 (Del. Ch. 2010)). With Comverge, the possibility that an absolute maximum allowable amount may have been reached is not out of the question. The decision also illustrates that the Court will not only look at the fees spelled out in the merger agreement, but at other potential payments that may be triggered and that effectively act as deal-protection measures.

Although the suit against the board was not entirely dismissed, the dismissal of the process-based allegations warrants attention. The decision represents another example of the latitude given to boards to satisfy their fiduciary duties, including their Revlon duties, even under a standard of enhanced scrutiny. Viewed objectively, the board could be said to have failed to obtain the best price for the shares of the company, given that it agreed to a discounted price and allowed the buyer to get away with possibly or probably breaching its standstill agreement. However, the board's overall handling of the process and engagement in the details of the negotiation were enough to establish good faith and win dismissal of those claims.

It is also worthwhile to consider how to reconcile Comverge with some other recent decisions of the Delaware Court of Chancery that dealt with issues of both good faith and aiding and abetting. In its Novell decision issued the same day, the Court examined the motivations of a target board to determine whether it had improperly favored one bidder over another (In re Novell, Inc. S'holder Litig., Consol. C.A. No. 6032-VCN, (Del. Ch. Nov. 25, 2014); see Legal Update, In re Novell: Board's Favoritism Toward Bidder Did Not Constitute Improper Motive for Finding of Bad Faith). In that decision, the Court apparently followed the doctrinal approach of Chen v. Howard-Anderson, which held that bad faith by the board can be established by showing that the board acted with improper motives, even though the board may have satisfied the Lyondell standard of not utterly failing to attempt to obtain the best price. The decision in Comverge is not in conflict with those decisions, as it too distinguishes between an examination of motive and an examination of the board's actions themselves. That said, Comverge does not spell out explicitly as Chen v. Howard-Anderson does that the two examinations constitute alternate approaches for establishing bad faith. Rather, Comverge seems to take it as a given that in any decision on Revlon claims, the Court ought to examine both the board's conduct and its motives.

The Court's decision in Comverge on aiding and abetting is also worth comparing against two other recent Chancery Court decisions. In Healthways, the Court considered it reasonably conceivable that a lender had aided and abetted the borrower board's breach of fiduciary duty by negotiating a "proxy put" in a credit agreement (Pontiac Gen. Employees Ret. Sys. v. Ballantine, C.A. No. 9789-VCL, (Del. Ch. Oct. 14, 2014) (TRANSCRIPT); see Legal Update, Pontiac GERS v. Ballantine: Chancery Court Declines to Dismiss Claims Against Board and Lenders Based on Loan Agreement Proxy Put). One month later, the Court dismissed a claim of aiding and abetting brought against the lead underwriters of Zynga Inc.'s IPO who agreed to waive certain lock-ups in such a way that benefitted some of Zynga's directors without benefitting the employee stockholders (Lee v. Pincus, C.A. No. 8458-CB, (Del. Ch. Nov. 14, 2014); see Legal Update, Lee v. Pincus: Loyalty Claim Survives Against Zynga Board for Authorizing Waivers of Post-IPO Lock-ups). An explanation for the different rulings offered in the Legal Update on Zynga was that the proxy put is problematic because it itself acts as a deterrent against stockholder action. Consequently, when the lender agrees to the proxy put, it directly brings about the deterrent effect. By contrast, a waiver of a lock-up is not necessarily wrongful in and of itself. Rather, the wrongfulness of a waiver depends on the particular circumstances of the offering and how other stockholders, who are subject to unmodified lock-ups, are being treated. These are factors that the board is expected to understand, but are not within the purview of the underwriters to anticipate, absent facts that prove that the underwriters were aware of the effect of their waiver in the particular situation.

With that approach in mind, it at first seems difficult to reconcile Comverge. The provision in question in Comverge, a break-up fee, is a deal-protection measure whose deterrent effect is well-understood. Every buyer understands the effect of a break-up fee and why too large a fee can prove problematic for the target board's fiduciary duties. In that regard, the break-up fee seems more comparable to the proxy put of Healthways than the lock-up waiver of Zynga.

However, in our view, all three cases can still be reconciled. The salient factor of a proxy put is not just that it acts as a deterrent against stockholder action, but that it exploits a division between the board and the stockholders. The concern is that the board will agree to a proxy put (particularly in the circumstances of Healthways, where the board had just gone through a proxy contest and was still under stockholder pressure) in order to inoculate itself against action by the stockholders.

A break-up fee is different. Admittedly, it is not a mere economic term like price, but is a deal-protection measure with potentially preclusive and coercive effects. Even so, the break-up fee does not exploit a conflict between the board and the stockholders. As long as the interests of the board and the stockholders are aligned, the board does not necessarily want a high break-up fee any more than the stockholders do; it simply wants to get a deal done. The Court has to review the board's decisions for their reasonableness, of course, but the ruling in Comverge to allow the claim to survive was based on the objective reasonableness of the termination payments. The Court had already concluded that the board was properly motivated and sufficiently independent and disinterested. HIG was therefore within its rights to negotiate a large break-up fee just as if it were an ordinary economic term, without concern that it would be considered to have exploited a conflict between the board and the stockholders.

In re Comverge: Chancery Court Rejects Motion to Dismiss Revlon Claim on Basis of 5.55% Break-up Fee Alone | Practical Law