Look at the Big Picture: A Message to Boards Seeking Business Judgment Rule Protection

In City of Sarasota Firefighters’ Pension Fund v. Inovalon Holdings, Inc., the Delaware Supreme Court provided additional guidance on the contours of the MFW framework and its application – a timely reminder that stockholders (and courts) are looking at the big picture when assessing disclosures in the MFW context.

In Inovalon, plaintiffs challenged the acquisition of Inovalon Holdings, Inc. (“Inovalon”), claiming that the company’s directors breached their fiduciary duties in connection with the transaction. In their motion to dismiss the complaint, defendants argued that the process leading to the acquisition satisfied the requirements of MFW and the company was thereby protected from the plaintiffs’ claims by the business judgment rule. Under MFW, in a controller buyout, the business judgment standard of review will be applied if and only if the transaction is conditioned upon its approval by an informed vote of a majority of the minority stockholders and by an independent special committee empowered to select its advisors and say no definitively, who meets its duty of care in negotiating a fair price. The trial court found that those procedural safeguards had been in place before substantive economic negotiation occurred.

On appeal, plaintiffs challenged two aspects of the trial court’s decision:

First, plaintiffs argued that Inovalon failed to condition the acquisition ab initio (from the outset) on the approval of the special committee.

Second, plaintiffs argued that the vote of the minority stockholders was not informed because the proxy disclosure was missing material information regarding the transaction.

The Delaware Supreme Court did not address the ab initio challenge because it reversed on the second basis, holding that the company’s disclosures were materially misleading. In so holding, the Supreme Court focused on disclosures regarding the conflicts of various advisors involved in negotiating the transaction on behalf of the company’s special committee, and the company’s alleged failure to adequately disclose the existence and magnitude of those conflicts.

Highlights of the Court’s Analysis

• The court determined that it was materially misleading to disclose that the special committee’s advisors “may” provide services to both the company and the acquirer. This was because at the time of the disclosure, both advisors were already working for members of the equity consortium acquiring the company. The court further rejected the argument that the conflicts were not material because they involved affiliates of the advisors. The court clarified that work performed by affiliates of an advisor (e.g., an affiliate bank of a financial advisor) does not insulate the retained entity from disclosure requirements.
• The court also found that although the company disclosed the existence of an advisor’s concurrent work for a member of the equity consortium, the failure to disclose the amounts paid for such representations was a material omission. Disclosing the fact of “customary compensation” was not enough. Further, the court found the fact that the proxy disclosed the advisor’s fees from prior representation to be particularly problematic because it created a misleading impression that the undisclosed fees were of similar magnitude to those that were disclosed.
• The court also found that the company’s description of the financial advisor’s role in market outreach did not align with special committee meeting minutes. These discrepancies were problematic from a disclosure perspective because it gave the misleading impression that the financial advisor was more involved in negotiations when, in fact, a different, conflicted advisor was taking the lead in negotiations.

Key Takeaways

This case offers practitioners, advisors, and board members helpful guidance to consider when seeking to position themselves for business judgment rule protection under MFW.

First, Delaware courts will not only analyze the circumstances surrounding the retention and management of advisors, but also how such information is communicated to stockholders. While a court will consider whether directors acted with due care when reviewing the engagement of advisors, it will perform a materiality-based assessment when determining the adequacy and accuracy of disclosures regarding the advisors’ role and their interests vis-à-vis the transaction and those involved in the same.

Second, magnitude matters. The court noted that while there is no bright-line rule holding that financial advisors always need to disclose the specific amount of their fees from a counterparty to the transaction, directors should consider whether such information is materiality enough to alter the “total mix of information.” In doing so, courts will consider the magnitude of fees received by advisors in concurrent or past transactions compared to fees expected to be received in a proposed transaction.

Finally, the court offered a reminder that disclosures and minutes should be carefully prepared and considered in tandem. The court pointed to discrepancies between the description of meetings and deliberations in the proxy statement and the company’s internal record, as described in the minutes of the special committee. The court advised “boards, committees, and their advisors … to take care in accurately describing the events and the various roles played by board and committee members and their retained advisors.”

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.