Two years ago, a Delaware Chancery Court decision (In Re Answers Corporation Shareholders Litigation) on an early stage motion to dismiss raised a number of concerns for private equity investors looking to sell publicly-traded portfolio companies to third parties. In a subsequent recent decision in the same case, the Chancery Court dismissed all claims against the private equity-appointed directors and other Answers board members. However, while that ultimate decision should reassure private equity sponsors, the original concerns raised by the court’s 2012 decision remain.
The case involved an all-cash, third party sale of Answers Corporation, a thinly traded Delaware public company, 30 percent of the stock of which was held by a financial sponsor. After the transaction closed, former Answers stockholders sued the company’s directors for breach of fiduciary duty, alleging, among other things, that the directors appointed by the sponsor breached their duty of loyalty because the sponsor’s desire for immediate liquidity gave rise to a conflict of interest with respect to the other stockholders. The plaintiffs built their case on the theory that the individual stockholders were able to sell their shares on the limited public market, whereas the financial sponsor, with its 30 percent stake, would only be able to quickly liquidate its interest at an attractive valuation if the entire company were sold. In its 2012 decision, the court found allegations that a sale provided the only efficient way for the financial sponsor to get liquidity and that such liquidity constituted a benefit not shared with the other stockholders to be sufficient grounds on which to state a claim for breach of loyalty against the directors appointed by the sponsor and ruled against the defendants’ motion to dismiss.
As we’ve noted in past, the court’s 2012 ruling meant that private equity investors would have to tread carefully in sales of publicly-traded portfolio companies, particularly where the public market for the company’s stock is not sufficiently liquid to provide a viable exit mechanism or where the sponsor has immediate liquidity needs. Without procedural safeguards in place – such as a special committee or minority stockholder approval—private equity sponsors may risk triggering a potential conflict of interest finding that would expose them to protracted litigation and entire fairness review.
In February, the Delaware Chancery Court, after two years of discovery, concluded that there was no factual evidence that the board breached its fiduciary duties or that the directors appointed by the financial sponsor breached their duty of loyalty. Specifically, the court found that a majority of Answers directors were independent of the private equity investors and that, contrary to the plaintiffs’ claims, the sponsor-appointed directors did not control the board or improperly dominate the other directors.
While the resolution of the Answers case is good news for private equity firms seeking clarity on legal issues that arise in the sale of publicly-traded portfolio companies, it does not resolve the most fundamental issue raised by the earlier decision – that the liquidity needs of a large stockholder may give rise to a conflict of interest and potentially subject the actions of the board to “entire fairness” review. The key findings in the Delaware court’s recent decision were that the company’s board complied with its fiduciary duties in the sale process and that the sponsor-appointed directors did not control or dominate the board. If the record had shown greater control by the sponsor directors, it is not clear whether or not the court would have found other grounds to dismiss plaintiffs’ claims that the these directors improperly manipulated the sales process in order to achieve liquidity for the sponsor. Thus, the Answers case continues to highlight the potential benefit to a private equity firm of (1) instituting a majority independent board following a public offering, particularly if the subsequent sale of the entire company (as opposed to a sell down into the market) remains a realistic possibility, and (2) taking care not to otherwise control the sales process when the company is sold.
It is also worth noting that the resolution in the Answers case comes on the heels of three years of litigation. Although the financial sponsor ultimately prevailed, it did so only after protracted litigation and a failed motion to dismiss. The inability to dismiss claims like those in Answers outright without a lengthy fact-finding process suggests that, despite a favorable resolution in Answers, even where a majority independent board exists, private equity sponsors who wish to sell publicly-traded portfolio companies to third parties need to take care to avoid any facts that could serve to undermine the independence of the non-private equity directors or of the sales process. In certain circumstances, private equity sponsors should even consider using procedural protections such as a special committee or minority stockholder approval in order to minimize litigation risk.
Based in New York, Gregory Gooding and Sue Meng are co-head and a corporate associate respectively of Debevoise’s M&A practice. A non-edited version of this article originally appeared in the spring 2014 issue of the Debevoise & Plimpton Private Equity Report.