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The Delaware Court of Chancery recently provided further guidance on directors’ responsibilities in cash mergers, including private equity deals. In In re Netsmart Technologies, Inc. Shareholders Litigation, the court applied Delaware law regarding the duty of directors to obtain the highest price attainable in a cash sale, also known as “Revlon duties” for the case in which they were defined, to an acquisition of Netsmart Technologies, Inc. by private equity firms Insight and Bessemer.

Although the case was in the context of a private equity deal, the court’s rulings are equally instructive to a board contemplating any cash sale and underscore that a board must engage in a deliberate and well-planned process in effectuating a cash sale.

Of most importance are the following points:

To fulfill its Revlon duties, a board must undertake reasonable efforts, supported by a logically sound process, to secure the highest price realistically achievable given the market for the company. There is no blueprint that constitutes a “fool proof” process, and “reasonable efforts” and a “logically sound process” will be reviewed against the specific market circumstances for the specific company. A board cannot merely rely on techniques previously approved by courts in different contexts involving different market conditions, such as a “post-signing market check.” Nor can the board rely exclusively on recent trends, such as the current prevalence of private equity buyers outbidding strategic buyers. Rather, the board must exercise its business judgment and take “reasonable efforts to maximize the return to investors.”

The Chancery Court noted the “potential utility of a sophisticated and targeted sales effort,” tailored to “a few logical buyers,” and the use of a banker with industry connections to market the company. The Chancery Court also noted that a board can legitimately consider the risks to the company from going to a broad group of potential buyers, but that the risk must be real and weighed against the board’s duty to obtain the best available price and terms. The board must make a “genuine and reasonably-informed evaluation of whether a targeted search might bear fruit.”

When there is a possibility that management will be retained, it should play only a limited role in any sales process. This is especially the case in private equity deals, in which management typically is retained and often receives compensation tied to the company’s post-merger success. The Chancery Court noted the obligation of the board or special committee of the board to control every aspect of the process, including the diligence process, to maximize value.

A board or special committee must be vigilant with respect to documenting all meetings and the bases for all decisions, in order to support any challenge to the deal as well as to maintain credibility with the court in the event the deal is challenged.

In a cash deal, management and the company’s financial advisor’s most current, best estimate of the future value of the company is material, given that the stockholders are being asked to accept cash at the time of the merger in exchange for forsaking participation in the company’s future value, and should be disclosed in a proxy statement seeking approval of the merger.

Events Leading Up to the Merger

Netsmart, a NASDAQ listed company, is a leading supplier of enterprise software to behavioral health and human services organizations and has a particularly strong presence among mental heath and substance abuse service providers. The court described Netsmart as a “micro-cap” company, which as of December 31, 2005 had an equity value of approximately $81.8 million. Netsmart achieved much of its growth through a multi-year acquisition process, which ended in October 2005 when it purchased its largest direct competitor, CMHC Systems, Inc. (CMHC).

Once the CMHC deal was complete, private equity buyers contacted Netsmart management expressing an interest in acquiring Netsmart. When management conveyed the overtures to the board in May 2006, the board followed management’s recommendation and made the decision at an “informal” meeting (minutes were not taken) to authorize Netsmart’s financial advisor, William Blair & Company, to try to sell the company and focus on a sale to a private equity buyer, excluding an active canvas of strategic buyers. A special committee of the board then solicited offers from seven private equity firms and received offers from four.

After an approximate four-month process of negotiations and due diligence with the private equity firms, in November 2006 Netsmart entered into a merger agreement with Insight and Bessemer. The deal valued Netsmart at $115 million. If the deal was consummated, Netsmart stockholders would receive $16.50 per share and Insight and Bessemer would take Netsmart private. Under the merger agreement, Netsmart’s executive team would be retained and they would share in an incentive option pool. The merger agreement provided for a 3 percent termination fee and included a provision pursuant to which Netsmart could accept, but could not solicit, a post-signing superior acquisition offer.

The Plaintiffs’ Claims

The same week that Netsmart announced the merger agreement, a group of Netsmart stockholders filed a lawsuit requesting that the court enjoin the merger. The plaintiffs claimed that the Netsmart board breached its Revlon duties by excluding strategic buyers from the auction process and that the proxy statement contained material omissions because it failed to disclose William Blair’s most updated estimate of the company’s future cash flow and the key projections supporting the estimate.

The Exclusion of Strategic Buyers from the Auction Process

The court found that the plaintiffs were likely to succeed on their claim that the Netsmart directors breached their Revlon duties by pursuing only private equity buyers to the exclusion of strategic buyers.

First, the Netsmart board did not have a sufficient information base on which to make the decision to exclude strategic buyers. The board based its decision on the fact that certain past efforts did not yield any interest from a strategic buyer: first, the purported pursuit by James Conway, Netsmart’s CEO, of strategic business combinations (between 1999 and 2005, Conway had informal conversations on the subject with at least half a dozen companies); and second, William Blair’s mention of Netsmart’s name, among numerous other companies and without representing that it had any authority to do a deal on behalf of Netsmart, during cold calls to companies in the IT health care industry (i.e., potential strategic buyers) in which William Blair was seeking business through a fee-generating deal. The court held that “these erratic, unfounded, and temporally-disparate discussions by Conway and William Blair” were an insufficient basis for the board’s decision in May 2006 that seeking a strategic buyer was not worthwhile. The court pointed out that neither management nor William Blair seriously analyzed the IT health care industry as it existed in May 2006, nor considered which companies would find Netsmart, as it existed in May 2006, to be attractive. As the court noted, Netsmart was a very different company in May 2006 than it had been in earlier years, having completed numerous acquisitions, especially that of CMCH.

Second, the court rejected Netsmart’s argument that the decision was based on the concern that potential confidentiality leaks would be detrimental to Netsmart in its sales efforts with customers and prospective customers. The court noted that there was no information in the record to indicate that the potential acquisition of Netsmart by a strategic buyer posed any threat to Netsmart’s customers or prospective customers and that Netsmart did not use confidentiality agreements when Conway and Blair held discussions with potential strategic buyers in the past.

Third, the court found that provisions in the merger agreement allowing for a post-signing market check – pursuant to which Netsmart could accept, but not solicit, a superior offer – did not cure the board’s failure to canvass potential strategic buyers. Although courts have previously approved post-signing market check provisions, such approvals were in different contexts – primarily during the active deal market in consolidating industries in the late 1990s and early 2000s involving large strategic players and their direct competitors. The circumstances surrounding those deals were different: Netsmart is a micro-cap company in a market niche, which reduces the likelihood that it would receive post-signing offers from strategic buyers. For example, a strategic buyer first would have had to notice that Netsmart was being sold, then invest the resources to make a hostile superior bid to acquire a company worth less than a quarter billion dollars, while also incurring the potentially high monetary and strategic costs of an unfavorable result. Given these barriers, the court held that the post-signing market check provision was unlikely to result in post-signing offers from strategic bidders and did not justify foregoing a canvass of strategic buyers.

Fourth, the court noted that the recent trend that private equity buyers are outbidding strategic buyers did not justify foregoing the pursuit of a strategic buyer. Merely because this type of private equity deal is prevalent in the large-cap arena, the court found, does not mean that a private equity buyer would necessarily outbid a strategic buyer in Netsmart’s circumstances. The court reasoned that, given Netsmart’s size, the synergies available to a strategic buyer might have given that theoretical strategic buyer the flexibility to outbid private equity buyers.

Fifth, the court also found that the Netsmart board’s arguments were severely hampered by the lack of board minutes documenting key decisions. The failure to keep minutes of the May 2006 meeting at which the board made the decision to pursue only private equity buyers made it difficult to determine exactly on what the “decision” was based. The fact that the special committee did not approve formal minutes until after the litigation was filed also was “not confidence-inspiring.” The court even went so far as to question whether these meetings took place.

Finally, the court commented on management’s involvement in deals in which it might be retained post-merger. Although the court found that the actions of Netsmart’s management did not constitute a breach of Revlon duties in this case, the court noted that such involvement can be problematic. Management could use such involvement to steer the decision toward a bidder who offers them the most favorable post-merger compensation deal. By attending certain special committee meetings and leading the due diligence process, Netsmart management was involved in the sale process. The court found that such involvement did not taint the process because all major decisions regarding the merger were made by the special committee at meetings which management did not attend and none of the members of the management team received a windfall compensation package. However, not all circumstances will be as clear as those in the Netsmart case and the practice generally should be avoided.

Disclosure Problems

Because the court found that the proxy statement omitted several material facts, it therefore enjoined the stockholder vote on the merger until the disclosure of such facts. In its ruling, the court emphasized that when stockholders are voting on a cash deal, information regarding the financial attractiveness of the deal is of particular importance. The court found that the proxy statement sent to Netsmart stockholders was deficient for two reasons, both of which related to William Blair’s discounted cash flow valuation – the basis for its fairness opinion and the projections underlying the valuation. First, the court found that, given that William Blair’s discounted cash flow valuation was based on projections and estimates for the years between 2007 and 2011, the estimates and projections for all such years were material and it was improper to omit such metrics for the years 2010 and 2011 from the proxy statement. The court rejected the defendants’ argument that such disclosure was not necessary because the information was not distributed to the private equity bidders, reasoning that, unlike the private equity bidders, the Netsmart stockholders were presented with William Blair’s fairness opinion and were being asked to vote on the merger, making Netsmart’s future prospects as a stand-alone entity directly relevant and material.

The court was equally concerned with the fact that the final, most updated William Blair projections underlying its ultimate discounted cash flow analysis and fairness opinion were not disclosed to the stockholders. Such projections took into account Netsmart’s acquisition of CMCH and management’s best estimate of Netsmart’s future cash flows. The court held that this was a material omission, reasoning that stockholders, who were faced with the question of whether to accept the cash in the merger in exchange for forsaking an interest in Netsmart’s future cash flow, necessarily would have found it important to know management and the company’s financial advisor’s final and best estimate of those future cash flows.

These rulings are significant for both buyers and sellers in preparing proxy disclosures for transactions in the future.

The Court’s Order

Although the court did not enjoin the merger, it did enjoin a stockholder vote on the merger until Netsmart disclosed the information set forth above to its stockholders. The court enjoined the vote in order to provide stockholders with the requisite information they needed to make an informed decision. The court reasoned that it was denying the request to enjoin the merger until Netsmart pursued offers from strategic buyers because:

(1) no higher bids for Netsmart came in after the announcement of the merger agreement and, therefore, the Insight/Bessemer deal was the only deal on the table;

(2) an injunction would provide Insight/Bessemer with a way out of the deal under the terms of the merger agreement, which could deprive the Netsmart stockholders of the benefit of the deal; and

(3) with the additional disclosures, the Netsmart stockholders would be able to make an informed decision whether to vote in favor of the transaction.

The court also considered the fact that the Netsmart board’s failure to test the market for strategic buyers likely would strengthen any claims dissenting stockholders might file based on their appraisal rights. That is, the “fair value” would be at issue more than in cases in which the company had been properly shopped to strategic buyers.

Conclusion

The court found that the Netsmart board’s decision to pursue only private equity buyers to the exclusion of strategic buyers almost certainly constituted a breach of Revlon duties and that there were material omissions in the proxy statement, but it tailored its order to avoid depriving Netsmart stockholders of a potentially beneficial deal while ensuring that they had the material information necessary to make an informed decision when voting on the deal. The Netsmart stockholders eventually approved the merger, on April 5, 2007.

To avoid a successful stockholder challenge resulting in a ruling enjoining a merger or a stockholder vote, the board of a target company in a sale of control, like a cash merger, should consider the processes identified at the beginning of this article in pursuing a transaction and craft a process designed to obtain the best price and terms, while taking into account the context in which the company finds itself. It is equally important for a board to engage experienced counsel from the outset, one that can guide it through the process in a way that minimizes the chances of a stockholder challenge or, at a minimum, maximizes the chance of defeating such a challenge.