Recent Case (M&A)

June 20, 2007
Board erred in restricting participation in limited auction to private equity players

Post-signing "window shop" period not adequate to satisfy Revlon duties in the case of a micro-cap, Delaware court rules

In re Netsmart Technologies, Inc. Shareholders Litigation, 2007 Del. Ch. LEXIS 35 (Delaware Court of Chancery)

This March 14, 2007 Delaware Court of Chancery decision arose from an auction process instigated by Netsmart Technologies, Inc., a NASDAQ-listed micro-cap medical software company. Vice Chancellor Strine, the author of the ruling, was critical of the Netsmart Board's decision to seek bids from private equity firms only, ignoring possible strategic buyers. An important aspect of the ruling was the Court's emphasis on the inadequacy of a "one size fits all" approach to structuring an auction process. It held that a process acceptable in a large-cap company context might not be appropriate for a smaller niche player. In Netsmart's case, the Board's decision to provide for a post-signing "window-shop" period - in which strategic buyers or others could theoretically have come forward - did not satisfy the Board's Revlon duty to seek the best price reasonably available. The Court reasoned that, as a little-known micro-cap, Netsmart was highly unlikely to attract a costly last-minute hostile bid.

The Court's analysis

The Court rejected the argument that the Board had been in contact with strategic buyers over the years but, having found little interest (and being concerned about confidentiality), had appropriately exercised its discretion in limiting the auction to private equity firms. The approaches to strategic buyers had been "erratic, unfocused and temporally disparate" and had taken place at a time when Netsmart was a very small start-up. Vice Chancellor Strine described this scattershot approach as "hardly the stuff of a reliable market check". The process that resulted in the decision to limit auction participants seemed questionable in light of the fact that the special committee overseeing the sale process had not taken minutes at its meetings (although it had created some ex post facto). The decision was especially suspicious, the Court noted, when one considered that the deliberations of the special committee had clearly been heavily influenced by management, which had an incentive to prefer a private equity deal that would keep it in place, likely with lucrative incentives.

The Court also found that the Board's concern that negotiating with a strategic buyer would inhibit sales of Netsmart's product - that is, when potential customers learned that they might soon be dealing with another company - to be rather disingenuous as it had not asked for confidentiality agreements in the course of any of its previous overtures to strategic buyers. In addition, unlike the situation with the two large competitors involved in the Oracle-PeopleSoft litigation, which the Board's counsel had apparently cited as precedent for its concerns about customer loss, the "rational customer" of a small niche player like Netsmart could hardly be unaware that "it and other of its competitors could be subject to acquisition" by a larger company - nor had any convincing evidence been produced that customers would be likely to abandon the Netsmart product as a result.

The size and nature of Netsmart's business necessitated a focused pitch to strategic buyers. The lesson is that meeting the standard in Revlon requires the target board to structure the sale process with a view to the particular circumstances of the company. Thus, as already noted, the post-signing market check afforded by the "window shop" clause - allowing the Board to consider but not seek out higher bids for a period after signing - was not adequate in these circumstances, even coupled with the relatively low 3% break fee. Companies (particularly small cap companies) undertaking a sale process will need to carefully consider whether a passive market check is appropriate, or whether the fiduciary out should be a "go shop" - allowing active solicitation after signing - rather than the "no shop" or "window shop" that might be acceptable for larger and better-known companies.

Limited injunction granted

Although the Board had not met its Revlon duty of seeking to maximize value once a change of control is inevitable, the Court declined to grant a broad injunction against Netsmart's merger agreement with the successful private equity firm, preferring to leave the agreement to a shareholder vote rather than risk losing the private equity buyer. However, it did enjoin the transaction from proceeding until the proxy statement had been amended to include the projections used by Netsmart's investment banker in arriving at the discounted cash flow (DCF) analysis that had grounded its fairness opinion.

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