December 24, 2020
An officer owes a duty of care to his or her shareholders. This fiduciary duty of an officer is especially important when the directors have asked the shareholders to approve a proposed merger. The chief executive officer in particular must make sure that the shareholders are fully informed about the proposed deal; meaning that they have sufficient relevant information in order to evaluate the proposed merger.
This deal involved the $23 billion merger of a public oil and field service company (seller) with the oil and gas unit of a public conglomerate (buyer). The buyer proposed a merger to the seller’s directors, where the seller shareholders would exchange their stock for $7.4 billion cash and stock in a new company that would contain the buyer’s oil and gas unit and the seller oil and field service business. After the closing, the new combined entity would be owned by buyer shareholders (62.5%) and seller shareholders (37.5%).
There were no audited financial statements for the buyer’s oil and gas unit. Instead, the seller board reviewed unaudited financial statements for the buyer’s oil and gas unit, management forecasts and a fairness opinion from its investment banker. The parties signed a merger agreement which required the buyer to deliver audited financial statements for its oil and gas unit.
Furthermore, the merger agreement gave the seller board a “fiduciary out” or right to terminate the merger if the audited financial statements differed from the unaudited financial statements in a manner that was materially adverse to the intrinsic value of the buyer’s oil and gas unit, excluding, among other items, changes in the amount of goodwill.
The buyer’s audited financial statements for its oil and gas unit reflected approximately $4 billion of goodwill impairments in 2014 and 2015 that were not reflected in the unaudited financial statements. The seller board determined that the differences between the unaudited and audited financials were not material and, that the seller board’s termination right in the merger agreement was not available.
The seller board asked the seller shareholders to approve the proposed merger. The proxy statement represented that, after receiving and reviewing the audited financial statements, the seller board decided that any differences between the audited and unaudited financial statements were not material and, therefore, the termination right in the merger agreement was not available.
The proxy contained the audited financials, which reflected the goodwill impairments, but did not contain the unaudited financials. The seller’s shareholders approved the deal which closed July 3, 2017.
The deal did not go well and the combined entity’s stock performance deteriorated. Seller shareholders sued the buyer, the seller board and its CEO and CFO, in the Delaware Court of Chancery.
All defendants escaped at the motion to dismiss stage except for the seller’s CEO, who has to fight on in court.
The court said that the seller’s management had a duty to make sure that the information supplied in the proxy statement fully contained all data necessary to evaluate the proposed merger; and that the unaudited financials of buyer’s oil and gas unit was “material” information. “In sum, the Proxy contained a material omission because it did not include the … Unaudited Financials …”
Turning to the seller’s CEO the court said: “Under Delaware law, the standard of care applicable to the fiduciary duty of care of an officer is gross negligence.” And in reviewing the shareholder’s allegations, the court felt that there was enough in the complaint to survive a motion to dismiss: “(The) … Complaint contains numerous allegations concerning … (the seller’s CEO) … involvement in the negotiation of the Merger, which is unsurprising given his multiple roles as Chairman of the Board, CEO, and President at the time. Most relevantly, the Complaint alleges that “Buyer CEO signed both the Proxy, as the Chairman and CEO of Buyer, and the Form S-4, as a person about to become a director of New Buyer.”
Continuing on the court said: “Although not overwhelming, this allegation is sufficient to support a reasonably conceivable claim that … (the seller CEO) … breached his duty of care with respect to the preparation of the Proxy he signed as … (the seller’s CEO). This is so, in my view, given the importance of the Unaudited Financials—the only source of … (the buyer oil and gas unit’s) historical financial information available to … (the seller) … before it signed the Merger Agreement—and given the categorical obligation in Section 5.04(c) of the Merger Agreement to attach the Unaudited Financials to the Merger Agreement. Perhaps discovery will show that the failure to attach the Unaudited Financials to the Proxy was inadvertent or handled by advisors on which … (the seller CEO) reasonably relied, but those factual questions cannot be resolved on the pleadings.”
This case is referred to as In Re Baker Hughes Incorporated Merger Litigation., C.A. No. 2019-0638-AGB, Court of Chancery of Delaware, (Submitted: July 16, 2020. Decided: October 27, 2020)
The CEO may still win the lawsuit.
An officer of a private company also has to be very careful when asking for shareholder approval of a transaction. The officers must fully disclose all material information.
The seller board was exculpated from personal liability for breaches of the duty of care under the seller’s certificate of incorporation, which is permitted by Section 102(b)(7) of the Delaware General Corporation Law. The court noted this provision can’t save an officer “for breaches of the duty of care under the Company’s 102(b)(7) provision.”
By John McCauley: I help people manage M&A risks involving privately held companies.
Telephone: 714 273-6291
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