A Closer Look At The ‘G’ in ESG: What Boards Need To Know When Examining Conflict Transactions
By James Hanson
In recent years, the focus on Environmental, Social and Governance (ESG) issues by investors and stakeholders has become more and more important. In the energy industry, when we think of ESG, we tend to focus mainly on the “E”, environmental. However, one needn’t look far within the energy industry to see that shareholder activism and even shareholder suits are on the rise. When reviewing the ESG scorecard of their companies, boards of directors need to also look at the “G” in ESG and evaluate how their own actions could be scrutinized.
This article will examine and provide sample cases of the steps a board of directors should undergo when examining conflict transactions in the energy industry. Specific areas covered include:
- Board of directors’ duties with regards to conflict transactions and whether these standards differ for partnerships vs. corporations.
- If the subjective standard excuses the board or conflict committee from looking at objective analysis.
- What a special committee or conflicts committee should do first to ensure that their approval will withstand scrutiny or challenge.
- Once a potential conflict transaction is identified, what steps need to be taken.
- Finally, recommend best practices for identifying a financial advisor/fairness opinion provider.
Business Judgement Rule
Legal responsibilities of board members have evolved over the years from application of decisions by courts into a doctrine commonly referred to as the “Business Judgment Rule”. The basic premise is that executives and directors aren’t liable for decisions that are made in good faith. The hallmarks of the “Business Judgment Rule” are acting independently, in good faith, on an informed basis (due care) with the honest belief that a transaction is in the best interest of the company.
Proliferation of Fairness Opinions
In 1983, a new concept in the context of board responsibilities with regards to conflict transactions emerged with the Delaware Supreme Court’s decision in Weinberger v. UOP, Inc. In this case, although the board had obtained a fairness opinion regarding a transaction that squeezed out equity ownership of many minority shareholders, the court was critical of the haste in which the fairness opinion was prepared and the lack of independence of the opinion’s issuer, an investment bank that had received significant fees from the transaction.
In this case, the Delaware Court introduced the concept of “Entire Fairness”, which encompasses both fair dealing (how the transaction is structured, where and how it’s initiated, how it was disclosed and negotiated with the directors and what and how approvals were received) and fair price (economic and financial considerations). All aspects of a transaction must be viewed as a whole to evaluate “Entire Fairness.”
In 1985, the Delaware Supreme Court, in Smith v. Van Gorkom, opened the door to the proliferation of third-party fairness opinions. This decision provided a safe haven for satisfaction of the Business Judgment Rule. In Smith v. Van Gorkom, the court criticized the directors of Trans Union Corporation as grossly negligent for relying on Chairman Van Gorkom’s valuation of a leveraged buyout transaction. The court specifically stated that the directors could have mitigated this negligence by obtaining a fairness opinion.
Do These Standards Differ For Partnerships?
For either private partnerships (i.e. private equity fund) or public partnerships (MLPs), the Delaware Limited Partnership Act gives greater leeway to partnerships than corporations to define contractually in their partnership agreements the standards for evaluating conflict transactions. This Act enables partnerships to expressly eliminate all common law fiduciary duties (except good faith and fair dealing). Well-drafted limited partnership agreements are explicit about how conflicts of interest are to be resolved.
For example, MLP conflict transactions are approved using the “Special Approval” clause in their partnership agreements. Recent court cases (Gerber v. EPE Holdings – Del 2013, Allen v. Encore Energy partners – Del 2013, Allen v. El Paso Pipeline GP – Del 2014) have focused on the application of good faith via objective vs. subjective beliefs that the action taken is in the best interests of the partnership. In each case, the court held that the subjective standard was enough. However, following Gerber, MLP partnership agreements have been drafted to explicitly state that a subjective standard will apply.
Forming A Board Or Special Committee
There are many best practices that can be followed to minimize the chance or success of a legal challenge. The first is the formation of a standing conflicts or special committee. It’s important that members of this special committee be independent, not only from the traditional NYSE or NASDAQ standards, but also from ownership, material financial ties to management or sponsors and/or former business relationships.
It’s also important that the special committee be empowered to act independently, negotiate with management and ultimately be allowed to “say no” if they don’t subjectively believe a transaction is fair.
The first step a special committee should take in the context of a conflict transaction is to hire its own legal and financial advisors. Typically, legal advisors are hired first so that they can advise on the process of interviewing other advisors and negotiating the accompanying engagement letter(s). For both the legal and financial advisors, it’s important that the special committee not simply use a firm suggested by management, but rather interview and select advisors of their choosing.
"There are many best practices that can be followed to minimize the chance or success of a legal challenge. The first is the formation of a standing conflicts or special committee."
The number one thing to look for in selecting a financial advisor is independence. Many of the court case rulings that have been against boards have criticized the financial advisor’s objectivity. While not exhaustive, several “best practices” to ensure independence include:
- Interview three or more firms that aren’t involved in the transaction under consideration.
- Don’t use a firm that earned or hopes to earn meaningful fees from the company (i.e., capital markets providers, auditors, lenders etc.).
- Don’t use the fairness engagement to “pay back” firms for other services.
- Make sure the fairness opinion fee isn’t contingent on the closing of the transaction.
In addition to independence, the courts have been increasingly critical of the qualifications of the firm providing the opinion. In Tousa (2012), the court criticized the opinion provider for a lack of industry expertise. Especially in the energy sector, finding a firm who’s experienced with the complexities of the subsector (i.e., upstream E&P, midstream, oilfield services, etc.) is critically important.
Qualifications should also include being a nationally recognized fairness opinion provider, preferably with a dedicated practice. While many firms provide fairness opinions, many view the practice as an “add-on” to other higher-fee businesses. A fairness opinion provider who has experience and expertise not only can provide the opinion (fair price), but they can also act as a guide to the committee regarding processes and best practices (fair dealing).
Fairness Opinion Process
In general, time is a very important factor when establishing due care with which the committee evaluates the transaction. As noted previously, a key criticism of the court in Weinberger was the cursory and rushed timetable (over the weekend). There can sometimes (often) be a conflicting dynamic at play, with company management usually looking for a fast approval. This is further emphasized in publicly traded entities where leaks of non-public information are a concern.
A comfortable timetable to evaluate a transaction is typically three to four weeks. However, the schedule is often compressed significantly. A shorter timeframe, however, can be supported, especially in cases where the advisor has an in-depth knowledge of the company and industry. Well-documented committee meetings are important. There should be multiple meetings (in-person is better, but telephonic can suffice) with the financial advisors so that committee members have a chance to digest material and ask questions. An approval vote should never take place during the same meeting in which the transaction is proposed by management or the sponsor.
In terms of due diligence, a special committee and its advisor must rely to a large degree on information provided by management. This is enough, if both the advisor and committee satisfy themselves through an appropriate level of due diligence. Success in this regard requires an open and responsive line of communication with management. Committee members and their advisors shouldn’t be shy about requests on specific issues and questions. Minutes should reflect the scope and depth of due diligence.
A special committee must be empowered to negotiate with management and, to the extent that they can be involved in that process, the earlier the better. That being said, one must be cognizant that the objective isn’t to create an adversarial environment simply for its own sake. For example, companies might ask if they should purposefully propose a transaction with a higher price than they expect so that the special committee has room to “negotiate.”
Many advisors will recommend this approach, but unfortunately no one-size-fits-all solution exists. Often, operating in the spirit of open and honest dialogue is more conducive to a better exchange of information, and while negotiating for a more favorable price or terms is certainly a good fact pattern, it still must be based on objective analysis. The committee that’s truly empowered to negotiate a transaction is, in practice, usually more evident by the process than by the price movement.
Fairness Opinion Analysis
The analysis supporting a fairness opinion should be consistent with best practices for a particular industry. One thing that advisors and committees should also be aware of is the increasing scrutiny that courts are giving to changes in analysis provided to the board. In Occam Networks (Del Ch. 2011), the court was critical of the comparison between the final board presentation and earlier versions given to the board. In Rural Metro Corporation Stockholders Litigation (Del. 2014), the court continued to be critical of the “time-series” analysis of board books and went even further to criticize the financial advisor by comparing their initial pitchbook to the final board-book. The court implied that the differences suggested “manipulation” of the analysis used for the fairness opinion. It’s critical that the reasons for changes in assumptions or analysis be thoroughly justified and documented.
"A fairness opinion provider who has experience and expertise not only can provide the opinion (fair price), but they can also act as a guide to the committee regarding processes and best practices (fair dealing)."
In addition to “time-series” differences in analysis, another potential area for concern is misinterpretation of sensitivity analysis. If “sensitivity” or “stress” cases are used, especially in board-books, it’s important they be explicitly clear those cases’ expected probability or expected likelihood vs. the “base” case. Certainly, sensitivity analysis can play a valuable role in evaluating a transaction, but only if it’s clear and can be understood as a stand-alone document in the context of litigation.
Timing of The Fairness Opinion Delivery
While it may seem counterintuitive to the discussion above, a fairness opinion should be provided right before the committee votes to approve the transaction. This is to protect the committee against material market movements that could have an impact on the opinion conclusion. However, it’s important for the committee to receive at least a draft of the analysis far enough in advance so that they can digest the information and ask questions as appropriate. They need to be 100% comfortable with the analysis before receiving the formal “opinion” and voting on the transaction.
Updates to Fairness Opinions
Several court cases have addressed the need for or requirement of updates to the analysis and/or opinion. In HA 2003 Liquidating Trust v. Credit Suisse (7th Cir 2008), the court found that the financial advisor wasn’t grossly negligent in failing to update or withdraw its opinion. However, in Southern Peru Copper (Del. Ch 2011), the court criticized the special committee for failing to revisit its recommendation following a significant movement in the price of Southern Peru’s shares (transaction had a fixed exchange ratio).
These potentially conflicting decisions emphasize the need to be very explicit in the engagement letter about when and why an update would occur. Advisors need to be proactive in making sure special committees understand how changes in external factors can subsequently affect value.
About the Author:
James Hanson is a Managing Director with Opportune Partners LLC, an investment banking and financial advisory affiliate of Opportune LLP, a leading global energy business advisory firm. James has nearly 30 years of commercial and investment banking, capital raising and M&A transaction advisory experience. Prior to joining Opportune, James served as Managing Director, Energy Transaction Opinions for all energy subsectors, at Duff & Phelps where he advised and executed 70 engagements representing over $50 billion of transaction value. These transactions included fairness opinions, solvency opinions, debt opinions and reasonably equivalent value opinions. James began his career specializing in energy investment banking at Salomon Brothers, Bear Stearns and Barclays Capital where he advised a wide variety of large cap and mid cap energy companies in M&A and public capital markets transactions, raising over $25 billion for his clients. James holds an MBA in Finance from The Wharton School, University of Pennsylvania and a BS in Finance from the University of Illinois. He received the chartered financial analyst (CFA) designation and is a FINRA Series 7, Series 24 and Series 63 registered representative.