I've been grappling with the titular question in writing the fourth edition of my Mergers and Acquisitions treatise
MBOs are a related party transaction writ very large. As agents and officers of the corporation, the top management team are fiduciaries of the entity and the shareholders. In that capacity, they are obliged to protect the shareholders’ interests and to help ensure that the shareholders get the best possible deal. At the same time, however, they are acting as buyers and have a selfish interest in paying the lowest possible price.[1] Unfortunately, in contrast to the extensive Delaware caselaw on most conflict-of-interest transactions, “the case law on MBOs is remarkably thin. Because there is no case squarely articulating the standard of review for MBOs, commentators generally reason by analogy from non-MBO cases that involve conflicts of interest.”[2]
One potentially applicable body of law comes from DGCL § 144, which governs contracts and transactions “between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest . . ..” The acquisition agreement between the corporation and the acquisition special purpose entity created by the management buyout group is just such a contract. Delaware caselaw provides that such transactions will be reviewed under the business judgment rule rather than entire fairness provided it has been approved by either a majority of the disinterested directors or a majority of the disinterested shareholders, provided there has been full disclosure of the material facts relating both to the transaction and to the management group’s conflict of interest.[3]
An alternative body of case law on which one might draw by way of analogy is provided by Revlon and its progeny. An MBO of a public corporation typically will constitute a sale of control. The firm goes from being owned by a large and diffuse collection of shareholders to being a privately held company owned by the management group and their private equity ally. As such, MBOs commonly should be subject to review under Revlon.[4] Accordingly, one might expect that the transaction should be subject to business judgment review if the target’s board complies with Corwin.[5] A widely used M&A treatise, however, claims that Corwin does not apply to MBOs because such transactions involve a controller on both sides of the transaction.[6] One might nevertheless argue that Corwin should apply to MBO for at least two reasons. First, the conflict of interest inherent in an MBO arguably is not as severe as is the case in controlling shareholder transactions. Unlike the case in which there is a controlling shareholder, the directors do not owe their election and positions to the management group. Second, Corwin’s rule that the business judgment rule applies when the transaction is approved by a fully informed vote of a majority of the disinterested shareholders parallels the analysis of shareholder approval under § 144.[7]
Having said that, however, there are some situations in which the entire fairness standard of Weinberger and its progeny applies to MBOs. In In re Cysive, Inc. Shareholders Litig.,[8] for example, a management buyout by the target’s CEO was subject to entire fairness review because the CEO was also the target’s controlling shareholder. In the older Mills Acq. Co. v. Macmillan, Inc.,[9] an MBO was subjected to entire fairness review where the board allowed the management group to control the decision-making process. In such cases, the standard of review should shift to the business judgment rule if the board complies with MFW.[10]
[1] For a detailed treatment of the conflicts of interest raised by MBOs, see Iman Anabtawi, Predatory Management Buyouts, 49 U. Cal. Davis L. Rev. 1285, 1293-1306 (2016).
[2] Guhan Subramanian, Deal Process Design in Management Buyouts, 130 Harv. L. Rev. 590, 650 (2016)
[3] See, e.g., Cohen v. Ayers, 596 F.2d 733, 740 (7th Cir.1979) (under New York law, after approval by the disinterested directors, “the business judgment rule is again applicable [to an interested director transaction] and the plaintiff can succeed only by meeting the burden applicable to challenges of any corporate transaction”); Benihana of Tokyo, Inc. v. Benihana, Inc., 906 A.2d 114, 120 (Del. 2006) (holding that “approval by disinterested directors, courts review the interested transaction under the business judgment rule”); In re Wheelabrator Tech., Inc., Shareholders Litig., 663 A.2d 1194, 1203 (Del.Ch.1995) (Approval by fully informed, disinterested shareholders pursuant to § 144(a)(2) invokes ‘the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction.’”); see generally Stephen M. Bainbridge, Corporate Law 180-83 (4th ed. 2020).
[4] On the current state of the law under Revlon and its progeny, see § 10.TBA.
[5] On Corwin, see § 10.TBA.
[6] Arthur Fleischer, Jr. et al., Takeover Defense: Mergers and Acquisitions § 3.03 (8th ed. 2018) (“A controller is viewed as standing on both sides of a transaction in a going private transaction where the controller is the purchaser or part of a management buyout . . .”). In Morrison v. Berry, 191 A.3d 268 (Del. 268 (Del. 2018), the Delaware Supreme Court declined to apply Corwin to a going private transaction not because it deemed Corwin per se inapplicable to such transactions but because the shareholders were given incomplete and false information. The transaction was a two-step acquisition whose first stage was a tender offer by a special purpose entity owned by a private equity fund. The transaction resembled a management buyout, because the CEO would end up with approximately 20% of the company’s equity after the deal closed. Id. at 273.
[7] Of course, under § 144 approval by either the disinterested shareholders or the disinterested directors suffices to invoke the business judgment rule. For an argument that “a per se requirement of a majority of minority condition appears inappropriate since in MBO transactions management often lacks a controlling stake in the target.” Matthew D. Cain & Steven M. Davidoff, Form over Substance? The Value of Corporate Process and Management Buy- Outs, 36 Del. J. Corp. L. 849, 899 (2011). Accordingly, they contend that “a special committee [of independent and disinterested directors] should be required in all circumstances when management is a participant in the buy-out group.” Id.
[8] 836 A.2d 531 (Del. Ch. 2003).
[9] 559 A.2d 1261 (Del. 1989).
[10] On MFW, see 10.TBA.
