In connection with the growing controversy over Hewlett-Packard's acquisition of Autonomy, the WSJ is reporting that HP is accusing Autonomy of having "made 'outright misrepresentations' to inflate its financial results" prior to the acquisition:
Last week, the company wrote down the value of Autonomy by $8.8 billion, blaming more than half the charge on what it said was Autonomy's misleading accounting. ... Autonomy used aggressive accounting practices to make sure revenue from software licensing kept growing—thereby boosting the British company's valuation. The firm recognized revenue upfront that under U.S. accounting rules would have been deferred, and struck "round-trip transactions"—deals where Autonomy agreed to buy a client's products or services while at the same time the client purchased Autonomy software, according to these people. ...
A person familiar with H-P's investigation said the company is confident the deals are improper even under the international accounting standards Mr. Lynch cites. "We've looked at this very closely," this person said.
In a statement issued Saturday, H-P said its "ongoing investigation into the activities of certain former Autonomy employees has uncovered numerous transactions clearly designed to inflate the underlying financial metrics of the company before its acquisition" ....
As a corporate governance teacher/scholar, my immediate thought was to ask "where was HP's board" and then "what's their liability exposure."
I can imagine two claims on the facts as we know them. First. H-P shareholders might sue the H-P board of directors for having made an uninformed decision to approve the merger. The key precedent here is Smith v. Van Gorkom, about which I have written here. In brief, that case held that directors who make an uninformed decision are not entitled to the protections of the business judgment rule. Instead, they face liability for damages caused by their breach of the duty of care. Instructively, Van Gorkom also involved a merger (although it was the target board being sued rather than the acquirer, as would be the case here).
Second, the shareholders might sue the H-P directors for having failed to exercise adequate oversight of the merger process. The key precedent here would be in re Caremark, about which I have written here. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate “information and reporting systems” are in place to provide the board and top management with “timely and accurate information.” The claim here would be that the H-P board failed to ensure that such systems were in place to supervise both the pre-merger negotiations and the post-merger integration process.
In either case, a key question will be whether the board ignored red flags that should have alerted it to problems with Autonomy's books.
Because liability generally requires a sustained or systematic failure on the board’s part, rather than just a few instances of inattention, red flags need to be "numerous, serious, directly in front of the directors, and indicative of a corporate-wide problem." Regina F. Burch, Director Oversight and Monitoring: The Standard of Care and the Standard of Liability Post-Enron, 6 Wyo. L. Rev. 481, 498 (2006).
An instructive Delaware precedent on this issue is Chancellor Chandler’s opinion in Ash v. McCall,[1] in which plaintiff shareholders sued the board of directors of McKesson HBOC, Inc. for, inter alia, failure to exercise proper oversight of financial matters in connection with the merger that formed the corporation. Plaintiffs relied heavily on “red flags” supposedly thrown up by various news reports casting doubt on the quality of the target corporation’s financial statements. In contrast, the defendant relied on the “clean bill of health” given those financial statements by the acquiring corporation’s financial advisors. Chancellor Chandler concluded that the plaintiffs had failed to state a claim:
When plaintiffs’ “red flags” are juxtaposed with the clean bill of health given by DeLoitte and Bear Stearns after due diligence reviews, the complaint permits one conclusion: that the McKesson directors’ reliance on the views expressed by their advisors was in good faith. What would plaintiffs have the McKesson board do in the course of making an acquisition other than hire a national accounting firm and investment bank to examine the books and records of the target company?[2]
In addition, the fact that HBOC’s management had responded to some of the media reports constituting plaintiffs’ red flags was not deemed to give the board of directors either constructive or imputed knowledge of the alleged accounting irregularities.[3] Post-McCall decisions have further explained that alleged “red flags” must be “either waived in one’s face or displayed so that they are visible to the careful observer.”[4]
So did the H-P board have sufficient such red flags to have been put on alert? The WSJ story recounts a certain amount of aggressive and unpleasant behavior on the part of senior Autonomy management, but that's not the sort of red flag in question. Instead, the issue is whether there were red flags that should have led the board to inquire into Autonomy's accounting practices.
Here the Journal's Heard on the Street column is suggestive:
Consider the multiple reports published about Autonomy by accounting research firm CFRA. Dating back to 2007, these raised questions about its lack of nonacquisition-driven revenue growth and unsustainable contributions to cash flow, among other issues. It would be surprising if no one at H-P doing due diligence on the Autonomy deal was aware of such concerns. And what of the back-office integration work once the deal closed? It isn't uncommon for small software companies to have funky revenue-recognition policies that need updating. Such issues are typically discovered immediately by acquiring companies. ...
Autonomy isn't the first problematic acquisition during [Chief Financial Officer Cathie Lesjak's] tenure as CFO. Others include H-P's purchases of EDS and Palm.
In light of Deloitte's giving the deal a clean bill of health, nothing in the Journal's reporting strikes this observer as rising to the level of serious and pervasive red flags that are required for liability, at least on sofar as the decision to merge with Autonomy.
As for board oversight of the merger integration, the main story reports that:
The company began seeing potential problems with Autonomy's business shortly after the deal closed earlier this year, say people familiar with the matter. The company clawed back some of the commissions paid to salespeople using questionable accounting methods, they said.
Autonomy tried to continue certain accounting practices that the new parent wouldn't allow, say people familiar with the matter. H-P fired Mr. Lynch in May, and soon afterward a member of his inner circle still at H-P told the company's general counsel about possible accounting problems.
Those look like pretty serious red flags. Having said that, however, what could an attentive board have done to prevent the loss? It's not at all clear that the board could have done anything sooner to reduce the damage suffered.
