Investment Banking

Steps in Managing Conflict Transactions

October 6, 2020  |  By Marc Sullivan  |  3 Minute Read

While public companies must adhere to very specific board composition rules, there are no such rules for most types of private companies.  Potentially as a result of either a lack of rules requiring the appointment of independent directors or the failure to see how they would be useful, many if not most closely held private companies have either few or no independent directors.  While it is arguable that this is a problem in any setting, it becomes a significant challenge when the board must consider a going private transaction, or one involving insiders or affiliated entities. These types of transactions are often referred to as conflict transactions.  

There is nothing inherently wrong with a conflict transaction.  Sometimes continued ownership by existing shareholders or control by existing managers is in the best interest of the organization potentially because they understand the challenges the organization faces better than others and/or they have shown a willingness to support it through difficult times. Whether that is the case or not, insiders or shareholders will at times find themselves interested in continuing to own or gaining a more significant ownership interest in a business even, at times, those that have become insolvent.

That said, conflicts raise legal questions. To increase the probability that courts apply the business judgment rule upon the inevitable legal challenge to such a transaction instead of the entire fairness standard, it is best practice for the board to create a special committee.  But who should be appointed to the committee and what practices would convince the court that the board acted independently?

Characteristics of Special Committee Members

1. Independent is Key

The special committee should consist solely of independent and disinterested directors. This is not an easy standard to meet and boards should understand each potential director’s financial, business, social, and personal ties before appointing anyone to the committee.  The court must be convinced that the special committee would be willing to make decisions that are averse to the interests of interested or conflicted parties in management or on the board.

2. Expertise in the Specific Kind of Transaction Under Consideration

Typically the company in question will not have any directors who meet this standard (both independent and disinterested) and will therefore have to appoint new independent directors to sit on the special committee.  It is critical in these situations to select a group with knowledge relevant to the situation that resulted in the creation of a special committee.  For example, in distressed situations, turnaround management experience and expertise will prove invaluable.  Similarly, as these are transactions, the members of the special committee should have relevant experience either overseeing or advising on merger and acquisition transactions.  Lastly, any member of a special committee should have demonstrated knowledge of and training in governance.

Best Practice on the Committee

1. Secure and Demonstrate Real Bargaining Power

The special committee will only be deemed independent if it can show that it has the power to act independently.  As such, the board resolution creating the committee should give it the power to make decisions without the approval of the shareholders or other interested or conflicted parties; to hire its own legal and financial advisors; to demand the relevant information required to make decisions independently; and to negotiate on its own.  Vesting those powers in the special committee by approving a properly constructed resolution combined with the committee’s demonstrated track record of wielding the approved powers are critical to convincing the court that any conflict transaction was approved at arm’s length.

2. Use Best Practice in Board Processes

There is a high probability that the announcement of a conflict transaction will result in litigation against the board.  As a result, the special committee should take care to ensure that they are using best practice in all board deliberations.  A professional, preferably an attorney, should be hired to take or review minutes.  In addition, a resolution should be used to formalize any significant decision.  Sound board processes can be critical to getting better outcomes in litigation.

Board Governance, Transaction Advice, and Phoenix

Over our 35+ year history, Phoenix professionals have worked with management teams and boards to create integrated solutions to complex business challenges. Our team has extensive experience functioning as board advisors and investment bankers to clients of all sizes, ownership structures, and industries. Through our unique blend of operational, financial, and transaction expertise, we assist clients facing business challenges, such as conflict transactions, to understand and evaluate their options and potential ramifications of courses of action.

Speak to a Phoenix professional today to learn more about our board advisory, financial advisory, and investment banking services.

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