Directors of a corporation are authorized to act on its behalf, ensuring proper management of corporate assets internally and having business dealings with outsiders externally. As fiduciaries, directors have duties of a fiduciary nature towards the corporation. However, when the corporation becomes the target of a proposed takeover, the decision made by its board of directors in response to the takeover offer may give rise to conflicts of interest between directors and the corporation.
If shareholders of the target disagree with the decision of the board of directors and take the case to a court, usually the court will examine whether the directors acted in contrary to their fiduciary duties by applying the business judgment rule, entire fairness standard, or enhanced scrutiny standard as appropriate to the circumstances.
Fiduciary duties of directors
Fiduciary duties of directors are specified in laws and regulations that include the Company Law, the Measures for the Administration of Takeover of Listed Companies, and the Measures for the Administration of Takeover of Non-Listed Public Companies. In a friendly takeover, conflicts of interest undoubtedly arise if the buyer reaches a secret deal with directors of the target with the purpose of getting the proposed M&A transaction done, or induces directors to agree to, and subsequently persuades shareholders into, accepting a lower bid price.
Even if directors of the target do not seek a secret deal, their motivation to keep the director position is likely to trigger conflicts of interest with shareholders of the target. In a hostile takeover, conflicts of interest are inevitable, because directors of the target might reject the offer, or take anti-takeover measures out of consideration for their own interest, given that the takeover is likely to deprive control and work opportunity of directors despite the possibility that it might provide material benefits to the target.
Being the entrusted operator of the target, and as part of their fiduciary duties, the target’s board of directors must make best efforts to ensure that their decision in response to the proposed takeover offer is in the best interest of the corporation and its shareholders under the prevailing circumstances.
Business judgment rule
It is a doctrine that the court should reasonably believe the decision made by directors of the target in response to a takeover offer is in the best interest of the target, if the directors act in good faith and on an informed basis in making the decision and related judgement. Involving only active decision-making activities of directors, the doctrine requires that directors making the decision are independent and disinterested. It must not apply if the directors are unreasonably wasteful, or commit any fraud or any other violation of laws in reaching the decision.
It is also critical that the directors have acted on an informed basis with due care exercised in relation to process, and that the decision in response to the takeover offer is reasonably made, especially for reasonable commercial purposes. If the directors act in bad faith, or in their own interest, this rule does not apply.
The business judgment rule is meaningful because it creates a presumption that directors comply with their fiduciary duties if they act without fraud, violation or self-dealing in making a business decision, even if the decision is subsequently proved to be wrong. Therefore, application of this rule not only encourages prudent risk-taking by directors, but also prevents courts generally without business capabilities from second-guessing the decisions of targets involving takeover offers.
Entire fairness standard
If the target’s directors making the decision regarding the takeover offer are related to the parties to the M&A transaction, obviously there are conflicts of interest between the directors and the target. To determine whether the directors acted contrary to their fiduciary duties, the court will request them to submit evidence that the decision was made in good faith and fundamentally fair, which the court will examine strictly. This is known as the “entire fairness standard”. To demonstrate entire fairness of their decision to the target, the director defendants must establish that the transaction is the product of both fair dealing and fair price.
Fair dealing encompasses such issues as how the transaction is timed, initiated, negotiated and structured, while fair price relates to financial considerations of the transaction, including but not limited to the asset being acquired, market value, profitability, future expectations and other value drivers. Normally, the court scrutinizes aspects related to fair price more strictly if no fraud is involved.
The burden of proof, which is tough under the entire fairness standard, falls on the director defendants. In some circumstances, they can shift the burden back to the plaintiff after meeting the initial burden of proof. In practice, the proof provided by the director defendants is much more likely to be acceptable to the court if it demonstrates that negotiations related to the transaction were carried out completely by an independent third party or parties.
Enhanced scrutiny standard
As hostile takeovers usually result in change of control over the target, defensive measures taken by directors may aim to maintain enterprise value, or their control or existing stake in the target. Courts typically apply another standard of review known as enhanced scrutiny for such cases due to concerns that defensive measures will escape review if the business judgment rule is applied, or application of the entire fairness standard may result in failure by most defensive measures to pass the review, which results in a significant rise in the cost of the transaction and, eventually, erosion of directors’ power to make decisions.
The enhanced scrutiny standard requires director defendants to bear the initial burden of proving that the defensive measures taken are reasonable. To prove reasonableness of their decisions, the directors will be subject to a review process of two stages. Stage one focuses on examining reasonableness, i.e., directors of the target must establish that they have reasonable grounds for believing that the hostile takeover poses a danger to effectiveness of the target’s operations. Stage two focuses on examining proportionality, i.e. the directors must be able to show that the defensive measures are proportionate to the threat, and there is reasonable connection between the two.
If the directors are able to satisfy these two stages of enhanced scrutiny, their defensive measures are then subject to the business judgment rule, which requires the plaintiff to bear the burden of proof to rebut the presumption under this rule. If they are unable to satisfy the enhanced scrutiny, the entire fairness standard will apply.
Author: Wang Jianrui is a partner and Yang Bin is an associate at East & Concord Partners