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Koehler v. NetSpend: Chancery Court Finds Board Acted Unreasonably in Sale Process
Practical Law Legal Update 7-530-8005 (Approx. 8 pages)
Koehler v. NetSpend: Chancery Court Finds Board Acted Unreasonably in Sale Process
by PLC Corporate & Securities
| Published on 30 May 2013 • Delaware |
The Delaware Court of Chancery ruled that the board of target company NetSpend acted unreasonably in its sale process by failing to conduct a market check, agreeing to tight deal protections (including enforcement of "Don't Ask, Don't Waive" standstill agreements) and relying on a weak fairness opinion.
On May 21, 2013, the Delaware Court of Chancery denied a motion for a preliminary injunction to enjoin the sale of target NetSpend Holdings Inc., holding that an injunction would threaten the stockholders' opportunity to obtain a premium for their shares. In spite of its denial of the motion, however, the Court in Koehler v. NetSpend Holdings Inc. found a reasonable likelihood that the board of NetSpend had breached its Revlon duties in its conduct of the sale process. In so doing, the Court held that when a target board decides to pursue a sale process with a single bidder, it must be "particularly scrupulous" in administering a process that will produce the highest possible sale price.
Background
The case arises from the merger agreement reached on February 19, 2013 between NetSpend and Total System Services, Inc. For a summary of the merger agreement, see PLC What's Market, Total System Services, Inc./NetSpend Holdings, Inc. Merger Agreement Summary.
NetSpend was formed in 2004 and operated as a private company until its IPO in 2010. Before going public, NetSpend had held several discussions with potential strategic buyers about a sale or merger transaction, none of which materialized. Each of these discussions created disruptions for NetSpend (such as issues with employee retention and difficulty entering into new commercial contracts) that made its board reluctant to launch a public market check before entering into an agreement with Total System Services, Inc. (TSYS). NetSpend also received inquiries from strategic buyers after its IPO, which also never came to fruition.
In 2012, before discussions began with TSYS, NetSpend's largest stockholder, JLL Partners and its affiliated funds, advised the NetSpend board that it was interested in selling all or a significant portion of its equity interest. Because NetSpend did not want JLL to sell its shares on the open market, it committed to help JLL privately sell its shares to a single buyer. To that end, in November 2012, NetSpend signed confidentiality agreements with two private equity firms for the purpose of providing non-public information to those bidders. Each of the two agreements contained standstill agreements that prohibited the firms from seeking an acquisition of NetSpend. These standstills, by their terms, would not terminate if NetSpend agreed to a transaction with a third party, as it eventually did with TSYS. The standstills also included "Don't Ask, Don't Waive" clauses that prevented the firms from requesting that NetSpend waive any provision of the agreement. Later that month, one of the firms made an offer to purchase JLL's stake at a price of $12 per share.
Simultaneously with its discussions with the two private equity firms, the NetSpend board also held negotiations with TSYS for a sale of the entire company. Throughout the discussions, though, the board insisted to TSYS that the company was not for sale and would not conduct a broad market check to seek better offers. The Court accepted this as a tactic that would give the appearance of a strong company that was not desperate for a buyer. A few days after receiving the $12 bid for JLL's stake, NetSpend received an indication of interest from TSYS to conduct a tender offer for 100% of NetSpend's shares at a price of $14.50 per share. This price was a premium to the $11.65 closing price of NetSpend's stock the last trading day before TSYS submitted its offer.
After receiving this indication of interest from TSYS, NetSpend maintained that it was not for sale, but that the board could be convinced to sell at a substantially higher price. NetSpend also retained Bank of America Merrill Lynch (BofA) to act as its financial advisor. BofA prepared a list of nine potential buyers that it presented to the board. The board discussed the companies on BofA's list and discounted several of them as unlikely to bid on NetSpend.
Eventually, the NetSpend board began to consider whether its Revlon duties had been triggered. In that vein, the board contacted a strategic bidder with whom it had once held discussions and notified the bidder that it was considering a change-of-control transaction. The bidder never responded, which the NetSpend board interpreted as a signal of the broader market's low interest in doing a deal for NetSpend. Also regarding its Revlon duties, the board insisted in its negotiations with TSYS that the merger agreement contain a go-shop provision that would allow it to canvass the market post-signing.
NetSpend and TSYS continued to bargain over the material terms of the merger agreement, with NetSpend attempting to extract a higher price if it could not obtain a go-shop. The parties ultimately came to an agreement with the following salient terms:
- A price of $16 per share.
- A $52.6 million break-up fee, which the Court characterized as 3.9% of the deal value.
- A no-shop with no go-shop exception, but with a traditional fiduciary out.
- As part of the no-shop, a prohibition against waiving any existing standstill agreements, which would contemplate the standstills with the two private equity bidders for JLL's shares.
- Matching rights for the buyer in the event of an acquisition proposal by a third party.
- Voting agreements that effectively locked up 40% of NetSpend's shares.
In connection with the agreement, NetSpend received a fairness opinion from BofA. The fairness opinion contained several common analyses, including a discounted cash flow (DCF) analysis, a comparable-companies analysis and a comparable-transactions analysis. Although the $16 price was deemed fair on the basis of the latter two analyses, the DCF analysis produced a range of acceptable prices from $19.22 to $25.52.
Following the announcement of the merger agreement, the private equity firm that had made the $12 offer congratulated NetSpend's CEO on obtaining a $16 per share price.
Key Litigated Issues
The plaintiff brought several Revlon and disclosure claims, some of which were relatively easily dismissed. Its stronger allegations were that the board breached its duty of care by:
- Running a flawed sale process that did not seek out alternative bidders.
- Relying on a weak fairness opinion by BofA.
- Agreeing to deal-protection measures that were unreasonable under the circumstances.
- Retaining the "Don't Ask, Don't Waive" standstill agreements with the two private equity buyers.
Outcome
The Standard of Review
The Court began its analysis with a review of the Revlon standard. As it explained, what is commonly referred to as a "Revlon duty" is not a separate fiduciary duty at all, but a standard of enhanced scrutiny of the target board's decisions once it decides to enter into a change-of-control transaction. This standard of review submits the board's actions to a test of reasonableness that it obtained the highest possible price for the company's shares. This standard is more exacting than a simple review for a connection to a rational business purpose, which is the standard the board is entitled to for ordinary business decisions (for more discussion of the rationality/reasonableness distinction, see Article, Delaware Courts Tackle Standards of Review for Directors; Results May Vary).
Because the NetSpend board agreed to sell the company in an all-cash, negotiated deal, its Revlon duties were triggered. The board therefore carried the burden of proving that they acted reasonably and engaged in an adequate process.
But Vice Chancellor Glasscock added a new element to the enhanced-scrutiny standard that would be applicable in single-bidder situations. In his words, by foregoing a pre-agreement market check and relying on an ambiguous fairness opinion, the NetSpend board had to be "particularly scrupulous" in establishing a process that would obtain the highest achievable price. Even when the board's decision to engage in a single-bidder process is reasonable, that decision "must inform its actions regarding the sale going forward, which in toto must produce a process reasonably designed to maximize price."
Single-bidder Process Not Per Se Unreasonable
With the Revlon standard applying, the Court first examined the board's decision to forego a broad market check. The Court looked at three prior decisions in which a Delaware court blessed the decision of a target board to conduct a single-bidder process:
- In Barkan, the Delaware Supreme Court upheld the board's decision because the market was aware of the target company's availability for a deal and because of certain tax advantages that were unique to the deal the board agreed to (see Barkan v. Amstead Industries, Inc., 567 A.2d 1279 (Del. 1989)).
- In Smurfit-Stone, the board's decision was deemed reasonable because the target company had recently emerged from a year-and-a-half long bankruptcy during which it received some indications of interest but no concrete bids, and because the board knew there were few interested strategic partners (see Legal Update, In re Smurfit-Stone Container Corp.: Delaware Chancery Court Confirms Revlon Applies to Cash-and-stock Mergers).
- Recently in Plains, the Court of Chancery noted that the target directors were informed and experienced in the industry, and the agreement's mild deal protections would give the market a "healthy period of time to digest the proposed transaction" (see Legal Update, In re Plains: Revlon Duties Met Despite No Special Committee or Pre-agreement Market Check).
In NetSpend, the Court similarly held that the directors were sophisticated enough to understand the financial side of the deal and were well-informed about the prospects for other bids given its experiences before the company's IPO. The Court also accepted that the decision to insist on not conducting a market check was reasonable in the context of placing the company in a strong position in its negotiations with TSYS. Therefore, the decision to only negotiate with TSYS, in and of itself, did not constitute a breach of the board's duty of care.
However, the single-bidder process did put the board's other decisions under even greater scrutiny.
Weak Fairness Opinion
In defending against the allegation that it improperly relied on a weak fairness opinion, the NetSpend board argued that it was exculpated by DGCL Section 141(e), which protects directors who rely in good faith on opinions by financial experts. The Court explained that this argument was beside the point because the board's reliance on the fairness opinion did not, in and of itself, constitute a breach of fiduciary duty. Rather, the reliance on a weak opinion provided context for the board's other decisions, because a weak fairness opinion is a "poor substitute for a market check."
In examining the BofA opinion, the Court noted that the comparable-companies analysis compared companies that were not comparable to NetSpend at all, while the comparable-transactions analysis relied on pre-financial-crisis transactions. The DCF analysis, meanwhile, indicated that the TSYS offer was grossly inadequate. In addition, the very fact that the DCF analysis came to such a different conclusion than the two comparables analyses threw the entire fairness opinion into question. Based on these factors, the fairness opinion was a "particularly poor simulacrum" of a market check.
The Deal-protection Measures
The plaintiff here conceded that the deal-protection devices of the TSYS-NetSpend deal have been found permissible in other merger contexts. It argued, though, that the package of devices was inappropriate in this context, given that the board had conducted no market check. In its review of the deal-protection measures, the Court upheld some measures while rejecting others as unreasonable.
Voting Agreements
The Court held that the voting agreements did not impermissibly lock up the deal, because they would terminate if the NetSpend board terminated the merger agreement. They were "saved" by the fiduciary out.
Matching Rights and Break-up Fee
Because the voting agreements will not preclude a third-party bidder, the only potential obstacles to a bid were the matching rights and $52.6 million break-up fee. In the context of a $1.4 billion deal, the Court noted that this break-up fee is within the range of fees held reasonable in the past.
No-shop Covenant
The Court noted that it is not per se unreasonable for a board to forego a go-shop provision, as the NetSpend board eventually did. However, a go-shop is a tool at the board's disposal that it must have a reasonable basis for giving up. This can be because the board has conducted a pre-agreement market check and will lose its bidder if it insists on a go-shop. Alternatively, as was the case in Plains, the board may anticipate a long pre-closing period during which the market will have sufficient time to digest the proposed transaction and produce competing bids. In NetSpend, however, the target board specifically proceeded on an assumption that it would reach the closing on an expedited basis, which removed a key justification for foregoing a market-check or go-shop.
"Don't Ask, Don't Waive" Standstills
The Court came down most forcefully on the NetSpend board for its decision to retain the "Don't Ask, Don't Waive" standstills with the two private equity bidders. The board had apparently not given this decision any particular attention, with the result that it "blinded itself" to any potential interest from those bidders. Vice Chancellor Glasscock acknowledged Chancellor Strine's decision in Ancestry.com that "Don't Ask, Don't Waive" standstills can be justified to the extent that they produce auction-like pressures on bidders. However, that justification was not relevant here, since the standstills were artifacts from previous deals that should have been waived when NetSpend entered into negotiations with TSYS. Instead, the situation here was more akin to Complete Genomics, where Vice Chancellor Laster enjoined the application of similar standstill agreements (see Legal Update, Court of Chancery Enjoins Enforcement of "Don't Ask, Don't Waive" Standstill Provision for a discussion of both of these decisions).
The Court noted that after oral argument, the parties waived the "Don't Ask, Don't Waive" clauses in the standstill agreements. The waiver did not produce any new bids. The waiver did not affect the Court's analysis of the board's conduct during the sale process, but did inform its decision on relief for the plaintiff.
Process Unreasonable, but No Injunction Granted
Based on the combination of the lack of a market check, reliance on a weak fairness opinion, deal protections (especially the "Don't Ask, Don't Waive" standstills) and the board's expectation that there would not be a long time for new bids to emerge post-signing, the Court ruled that:
- The board would likely fail at trial to meet its burden of proving that it acted reasonably.
- The sale process, reviewed as a whole, was unreasonable.
In spite of this finding, the Court declined to enjoin the transaction. The Court noted that the litigation involved in this case had managed to postpone the closing, and the "Don't Ask, Don't Waive" clauses had been waived, yet still no bidders had emerged. Although there remained potential for harm to the plaintiff, the magnitude of the harm would not exceed the potential harm of an injunction, if the current agreement would not proceed to closing. The balance of equities weighed in favor of allowing the stockholders to vote on the transaction.
As a postscript to the decision, on May 29, the parties announced that they had amended their merger agreement. The amendments include a lowering of the amount of the break-up fee, reduction in the buyer's matching-rights period, and other changes.
Practical Implications
The NetSpend decision represents the latest addition to the growing jurisprudence in Delaware on "Don't Ask, Don't Waive" standstills. The takeaway from these decisions is that "Don't Ask, Don't Waive" clauses can be useful at the negotiating stage, because they can mimic an auction scenario and help elicit the best possible bid. However, once the transaction moves on to the stage of stockholder approval, the board must consider waiving these clauses. If it fails to do so, let alone if it retains them in the definitive merger agreement as in NetSpend, it creates the possibility that the stockholders will not have been presented with the best possible opportunity to maximize the return on their investment.
The decision also makes for a useful counterpart to the Plains decision earlier this month. Although it is clear that a single-bidder process with no market check can pass muster in Delaware, the full context of the process and the ultimate agreement reached still leave a possibility that the board's conduct will be found unreasonable. The Court's "particularly scrupulous" phrasing and warning that a single-bidder process informs the rest of the analysis should be treated by practitioners as a particularly enhanced form of scrutiny under Revlon.