What's a Board's Revlon Duties when the Deal's 'Too Good to be True'?

Yesterday I had breakfast with a friend who’s quite accomplished in Corporate Law. Among other things, we had a good conversation regarding a Board’s Revlon duties when BuyCo uses significant leverage in its proposed acquisition.

In particular, we discussed the obligation of a Board of Directors when a bid for the company is so large that its likely consequence is to saddle the company with so much debt that its future cash flows may be insufficient to pay its obligations. Said simply: what if the bid is “too good to be true” – it’s a boon to current stockholders but a death sentence for the company’s ongoing viability?

I was prompted to ask him this question because of Tender Offer (Dormans). Dorman, reflecting on the offer Natomas received from Diamond Shamrock, reflectively poses the question: “when management is faced with the threat of a takeover, the question becomes: To which shareholders should one feel responsible? Investors seeking short-term profits will be best served by the highest takeover price, but those who want to see the best long-term results and have the strongest company emerge may be better served by [incumbent management fighting the takeover].” (p30). And later he again asks, “how strong a company would the new Diamond Shamrock be? What would be the impact on future profits of its borrowing $700 million to complete the transaction?” (p36).

The answer is straightforward: it depends. If the consideration is straight cash, then management should only look to the highest bidder. But if the consideration is stock from BuyCo, then management must be more careful. In that case, the Board has to consider that its shareholders will become owners in the new company (and its accompanying higher debt load).

This obligation of the Board is partially absolved by obtaining a “solvency opinion” (also from WSJ Deal Blog) from a banker. The solvency opinion is needed whenever the post-acquisition company acquires a significant amount of debt relative to its size. This is likely to occur either in a merger-of-equals or in a leveraged buyout. Thus, there the growth in private equity-led M&A during the “sixth wave” of M&A (2004-2007) made the solvency opinion increasingly important.

What was the consideration in the Natomas bid? It was a bit tricky. Diamond-Shamrock offered $23/share for the first 51% of outstanding Natomas stock, and then offered Diamond-Shamrock stock worth $23 for the remainder. So that transaction fell somewhere in the middle; not all cash, but not all securities. Though this offer probably moves into a gray area, I would guess that the Board has an obligation to ensure the resulting company is solvent. Therefore, simply seeking the highest bid will not do. Instead, the Board would have to be confident that the resulting corporation would have sufficient cash flow to service its debt.