A Teachable Moment on Adequate Disclosures
Full and accurate disclosure of information by a corporation to its stockholders is a basic component of obtaining consent to mergers, acquisitions, tender offers and other fundamental transactions. All material information must be disclosed and the disclosure cannot be materially misleading. What is sufficiently material for disclosure turns on what a reasonable investor would consider important when deciding how to vote on, or participate in, the transaction. The information must be accurate, full and a fair characterization of events so as not to be deemed materially misleading. While these standards are relatively simple to articulate, putting them into practice can be considerably more complex. What to disclose and how to phrase the disclosure is event-driven. Each deal is unique, and so the content of a particular disclosure must be transaction-specific.
When the purchase or sale of securities is involved, the key statutory provisions governing disclosures to stockholders are found in the Securities Act of 1933, the Securities Exchange Act of 1934, and the rules and regulations promulgated under such statutes. However, in addition to statutory grounds giving rise to liability for inadequate disclosure, there is also a risk of stockholder claims of breach of fiduciary duty by directors of the corporation. Delaware law recognizes a duty to disclose fully and fairly all material information known to a director when seeking stockholder approval or ratification of a transaction. The duty of disclosure is not an independent duty, but rather arises out of, and includes elements of, the duties of care and loyalty owed by directors to the corporation and as a result can impact whether the business judgment rule or the more stringent entire fairness rule will be applied in evaluating a breach of fiduciary duty claim.
The duty of care requires that directors make decisions in good faith and in a reasonably prudent manner — this includes the obligation to make careful, informed decisions and devote sufficient time to obtaining and reviewing information. The duty of loyalty requires that directors act in the best interest of the corporation and its stockholders and not put their personal interests ahead of the corporation and its stockholders. Duty of disclosure cases can arise in the context of a transaction where a director has a personal interest in the transaction that differs from the stockholders generally or where the directors do not use reasonable care to disclose all facts that are material and that could reasonably be obtained in their position as directors. There accordingly is additional pressure to adequately and accurately disclose information in seeking consent to a transaction because doing so likely will affect the ability to foreclose a post-transaction damage action by dissenting stockholders.
In Delaware, the business judgment rule is generally the default standard applied in determining if a board acted properly in accordance with its fiduciary duties in approving a transaction. Such a standard protects the board from second-guessing by the courts as it applies a presumption that in making a business decision, the directors of the corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation. The Delaware Supreme Court’s decision in Corwin v. KKR Financial Holdings LLC established that approval by a fully informed, uncoerced majority of the disinterested stockholders warrants review of the transaction under the deferential business judgment rule, assuming the more onerous entire fairness standard does not otherwise apply. As such, the Corwin doctrine underlines the importance of adequate disclosures — so that stockholder approval cleanses a deal from post-transaction challenges.
As a stark reminder that implementing adequate disclosures is easier said than done, in Morrison v. Berry the Supreme Court recently provided “a cautionary reminder to directors and the attorneys who help them craft their disclosures: ‘partial and elliptical disclosures’ cannot facilitate the protection of the business judgment rule under the Corwin doctrine.” Morrison involved a going-private transaction in which a company had agreed to be acquired by a private equity firm in a transaction in which the founder had agreed to roll over his existing shares into shares of the acquirer rather than selling his shares alongside other stockholders pursuant to a cash tender offer by the acquiring private equity firm for the shares of the other stockholders of The Fresh Market.
In a tender offer, the company that is the subject of the takeover must file with the U.S. Securities and Exchange Commission its response to the tender offer on Schedule 14D-9. And so, Fresh Market filed a Schedule 14D-9 articulating the board’s reasons for recommending stockholder acceptance of the tender offer. The Schedule 14D-9 included a narrative of the events leading up to the transaction. The private equity firm filed a Schedule TO that included its own narrative of the transaction background. Such a filing is required of any party who will own more than 5 percent of a class of the company’s securities after making a tender offer.
Based, in part, upon materials obtained from Fresh Market through a books and records demand under Section 220 of the Delaware General Corporation Law, a stockholder identified potential discrepancies between the Schedule 14D-9, the Schedule TO, and the information contained in the company records. More specifically, the stockholder alleged that the disclosures were materially incomplete and misleading because:
- They did not inform the stockholders that the company founder, who controlled 9.8 percent of the stock, was not candid with his fellow board members when confronted about his relationship with the private equity firm and denied the existence of any pre-existing agreement with the acquirer;
- The Schedule 14D-9 did not disclose the company founder’s pre-existing agreement with the acquirer to roll over his equity interest if the acquirer reached a deal with the board;
- They improperly suggested that the founder would participate in an equity rollover with any buyer, whereas in actuality he expressed to the board that he was only doing so if the private equity firm was the buyer;
- They did not disclose the founder’s “threat” to sell his interest in the company if the board did not engage in a sale process; and
- They mischaracterized that the board formed a strategic transaction committee to explore a sale process because the company could become the subject of shareholder pressure, when in fact the company was already subject to such pressure.
The tender offer by the private equity firm closed with 68.2 percent of the outstanding shares validly tendered. The stockholder then pursued a breach of fiduciary duty claim against the board, in part contending that the disclosure deficiencies prevented stockholders from making an informed decision about the tender offer. The lawsuit was dismissed at the trial court level based upon reasoning that the amalgamation of information disclosed sufficiently apprised stockholders of the pertinent facts to warrant application of ratification under Corwin (extended to tender offers in Delaware)
Reversing the dismissal, the Supreme Court reminded those tasked with preparing disclosures that failure to include full and complete facts underlying the background narrative is problematic. The Supreme Court stated that whether omitted information is material includes facts that a stockholder would “generally want to know in making a decision, regardless of whether it actually sways a stockholder one way or the other, as a single piece of information rarely drives a stockholder’s vote.” The test is whether there is a substantial likelihood that a reasonable stockholder would have considered the omitted information important when deciding whether to tender shares or seek appraisal.
Morrison accordingly provides a teaching moment for boards and their advisers to not overlook the significance of adequate disclosures. Reliance on disclosures with form language or incorporation of other documents by reference may not be sufficient. For example, in Morrison several of the facts identified by the stockholder were arguably covered by the Schedule TO, but the decision implies that neither incorporation by reference of the Schedule TO nor the fact that the Schedule TO was also available to the stockholder and provided certain omitted information cured the deficiencies in the Schedule 14D-9. To the extent possible, effort should be made to coordinate the narratives disclosed by the parties. Ratification under Corwin can be a powerful tool for heading off stockholder challenges, but only when care is taken to fully and accurately inform the stockholders of all material information in a manner that is not misleading.