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Sunday, November 4, 2007

ACS: The Legal Analysis

It is hard to know where to begin.  That is my first thought when confronting the legal issues arising from the fiasco at Affiliated Computer Services.  When we last left this matter on Friday, the independent directors of ACS had resigned pending the election of new directors, filed suit in Delaware Chancery Court for a declaratory ruling that they did not breach their fiduciary duties in negotiating the potential sale of ACS, and sent a letter to Darwin Deason, Chairman of the Board of ACS and controller of 40% of the voting stock of ACS (but only 10% of the economic interest), accusing him and ACS management of breaching their own fiduciary duties in unduly favoring a deal with Cerberus.  For his part, Deason in his own letter, demanded the ind. directors' “immediate resignations” because of “numerous and egregious breaches of fiduciary duty and other improper conduct,” related to their own running of the Cerberus auction.  Then the lawyers for each of these groups (Weil for the ind. directors/Kasowitz for Lynn Blodgett CEO of ACS) exchanged their own letters making further allegations of inappropriate conduct against the other parties (though Weil alleges Kasowitz's letter was written by Deason's counsel Cravath, although Cravath may also be company counsel?!).  Throwing all of this into the mix, two of the firms involved -- Cravath and Skadden -- are now being accused of acting in a conflicted manner.  Whew, I'm exhausted already. 

Preliminary Observations 

  1. The lawsuit by the Cerberus independent directors was a smart tactical move likely to preempt a similar suit against them brought by Deason (read the complaint here).  Now the independent directors can be viewed as the plaintiffs, the good guys and drive the litigation.  Plus, they can now engage in discovery, amend their complaint as necessary and have a bargaining chip against Deason.  And most importantly, since they brought this action in their capacity as directors under Delaware law they can receive indemnification under DGCL 145 and, in fact, under ACS's By-laws (s. 33) automatically are advanced attorney's fees in prosecuting this action.  Nifty.  See Hibbert v. Hollywood Park, Inc., 457 A.2d 339, 343 (Del. 1983) (holding that per the contractual indemnification provisions of the company the directors only needed to be a party to the lawsuit not the defendants to be indemnified).
  2. Relatedly, my big question is why didn't the ind. directors here sue Deason and management for breach of their fiduciary duties?  I find this almost certainly intentional omission odd.  Perhaps it was because they need/want to do so on behalf of the company but cannot currently call a board meeting to so act (see the next point).  Although a derivative suit is possible.  Hmmmm.
  3. The future governance of ACS is a nightmare.  First, per the By-laws (Art. 16) only Deason or the CEO can call a special meeting of the Board.  In the interim, per DGCL 141(f), they can only act by written consent with the approval of all the directors (there is no By-law or Certificate of Incorporation provision that I saw to the opposite).  So, the ind. directors are stuck, waiting for the next meeting to act.  Deason has a clear incentive here to postpone the holding of the next board meeting until the next shareholder vote in order to prevent the ind. directors from acting and perhaps firing him.  This means board paralysis for months until then; a terrible way to run a company.   
  4. Deason's employment agreement gives him unprecedented control over the company.  I've actually never seen anything like this structured in this manner.  Under his employment agreement he is given sole authority for:
    • (i) selecting and appointing the individual(s) to serve in, or to be removed from, the offices of Chief Executive Officer, President, Chief Financial Officer, Executive Vice Presidents, General Counsel, Secretary and Treasurer and (subject to appropriate charter amendment confirming the Executive's authority to fill such vacancies) to fill any director vacancies created in the event any such removal from office, (ii) recommending to the Board individuals for election to, or removal from, the Board itself, (iii) recommending to the Compensation Committee to the Board, or as applicable, to the Special Compensation Committee to the Board, salary, bonus, stock option and other compensation matters for such officers, (iv) approval of 3 4 acquisitions to the extent authority has previously been granted by the Board to the Executive in his capacity as the member of the Special Transactions Committee (except to the extent the Executive had previously delegated authority to the President with respect to such acquisitions which do not exceed $25 million in total consideration), (v) spending commitments in excess of $5 million, and (vi) approval of expense reports for the CEO and CFO.

I love the last two -- he has to approve the expenses of the CEO?!  How independent of him is she?  In any event, hornbook law in Delaware is that, under DGCL 141(a), the business and affairs of every corporation shall be managed by or under the direction of a board of directors, except as may be otherwise provided in its certificate of incorporation. I'm still tracing through all of the (complicated) governance provisions, but my preliminary conclusions are that they didn't put enough of the above in the Certificate, but rather put most of Deason's powers in the By-laws and the rest in the employment agreement itself.  I'll have a longer post on this later this week (I promise) once I'm done with my analysis, but my preliminary view is that these provisions violate 141(a) because to be effective in limiting the board's power they must be in the Certificate.  They are not.  In any event, this is the poorest of the poor in corporate governance to say the least.  This is particularly true when your CEO was famously accused of threatening to kill his personal chef.

4.    This company is a mess.  Only the bravest (or the foolhardy) would invest in this situation. 

The Case Against the Ind Directors

As outlined in Deason's and Kasowitz's letters, the case against the ind. directors is as follows:

  1. They refused to accept the Cerberus offer negotiated by Deason with a go-shop and "low" break-up fee and instead insisted on conducting an auction of the company.
  2. Relatedly, they failed to present the Cerberus offer to the shareholders directly.   
  3. They inappropriately provided proprietary information to a competitor of the company.
  4. They received and relied upon the advice of company counsel, Skadden, without authorization of ACS.
  5. They paid themselves substantial fees (>100K each) for serving on the ind. committee. 

The Case Against Deason

  1. He worked with Cerberus to force their deal through against the will of the special committee.  Specifically, he entered into an initial exclusivity agreement which he refused to waive for three months. 
  2. Deason and management worked to ensure that other bidders did not receive full information or management cooperation.
  3. Deason and management refused to permit the ind. committee to meet with company counsel.
  4. Deason attempted to coerce the ind. directors to resign last Tuesday at a board meeting. 
  5. Deason took all of these actions in order for his own personal financial gain through the bid with Cerberus.  Management followed his lead because they were beholden to him and their post-transaction employment depended upon it. 

The Legal Analysis

My opinion is that the ind. directors here did the right thing.  Deason, on the other hand, engaged in conduct that Delaware courts have historically condemned.  There is not enough here for me to give an opinion on management's liability, but to the extent they followed Deason's direction they are also liable. 

This is actually a relatively simple case.  Since Smith v. Van Gorkom, the Delaware courts have been adamant that the sale of the company is something for the board to decide.  It is not something that can be forced upon it by a singe executive (or here Chairman).  Moreover, the Delaware courts most recently in Topps and Lear have repeatedly endorsed the idea that the sale process, whether it be by the Board or a comm. thereof, is something for the board to set, even when the company is in Revlon mode.  Here, the board's refusal to accept a pre-negotiated deal that Deason had a personal financial interest in appears quite justified.  Other bidders would likely be deterred by his and management's involvement and financial interest; something which a go-shop and low break-up fee would not ameliorate.  In particular, it is increasingly recognized that go-shops provide only limited benefits and do not work particularly well when the initial deal is one involving management.  The head start and management participation is too much of a deterrent for bidders. Thus, my hunch is that on these bare facts, Deason is likely in the wrong and a Delaware court would not only rule so but rule Deason (and likely management) breached their fiduciary duties by unduly attempting to influence the auction process.   

As for the other claims:

  1. I can't see how wanting to consult with company counsel can ever be a bad thing. 
  2. The compensation of the ind. directors here is high but not extraordinary or something that would otherwise disqualify them. 
  3. The provision of proprietary information could be troubling.  We need more facts to make this determination. 
  4. Deason should ultimately be careful in his crusade here.  As Conrad Black proved, the Delaware courts do not look kindly on mercurial, imperial controlling shareholders. 

Possible Legal Conflicts Claims

  1. Skadden provided advice to the ind. directors when it was company counsel.
  2. Cravath is now company counsel when it had previously been Deason's counsel.

As I said, I'm not sure I see the problem in the first.  The second may be more problematical to the extent ACS may have a claim against Deason.  Moreover, what is Cravath, a nice, reputable firm doing sullying its name in this mess?  They likely realize the same thing which is why Kasowitz is taking the public lead here. 

http://lawprofessors.typepad.com/mergers/2007/11/acs-the-legal-a.html

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