The role of directors in acquisitions: directors should do more than is minimally required under the business judgment rule.

Directors are often requested to approve significant acquisition proposals, which typically are accompanied by rosy management projections which more than justify the purchase price. Directors should be skeptical of acquisition proposals which promise significant cost savings, major synergies and considerable growth potential. A recent example is the purchase by a specialty retailer of another specialty retailer for approximately $517 million in February 2006, with a press release claiming "significant growth potential,' enhanced "shareholder value," and "cost synergies," and the subsequent sale announced on June 2009 of that same company for approximately $75 million, which was claimed to be a "significant strategic step forward " to enable the acquirer to focus on its core of business.

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Director skepticism is more than justified by numerous academic and other studies which indicate that more than a majority of mergers and other acquisitions "fail," depending upon your definition of failure. Moreover, some have argued that the rise in CEO and other executive compensation is directly linked to the size of the organization, thereby providing a management incentive for mergers and other acquisitions and may be partially motivated by CEO "hubris."

In considering any significant acquisition proposal, directors must comply with the minimum legal duties under the business judgment rule and conscientious directors should do much more. Directors can satisfy their minimum legal requirements and nevertheless still approve an acquisition which is disastrous to shareholder value. Not unimportantly, directors who approve disastrous acquisitions are less likely to be invited to serve on other boards of directors.

For purposes of this article, we will assume that the management acquisition team does not have a demonstrated track record of having completed a large number of successful acquisitions, such as General Electric. We will also assume that the board is considering a significant merger or acquisition opportunity, with substantial cost to the company, that the proposed opportunity does not involve a change in control of the company itself, and that there is no conflict of interest because of the board or management involvement with the target.

At minimum

To comply with the minimum legal requirements of the business judgment rule in order to protect the directors from personal liability, the board should have several meetings to consider any significant acquisition proposal, spaced out over a reasonable period of time. The board should require complete presentations by management and outside experts on the proposed acquisition, including a draft of the proposed acquisition agreement, and ask reasonable and hopefully probing questions. These standards result from such cases as Smith v. Van Gorkom and a host of other Delaware court cases which describe the procedures necessary to help establish a business judgment defense for directors.

Aside from establishing a business judgment defense, conscientious directors should understand best practices in effecting mergers and acquisitions. No company can grow without assuming some risk, notwithstanding the dismal success record of mergers and acquisitions. Therefore, the task of the conscientious director is to balance risk and reward. Although directors should not micromanage ordinary business decisions, directors may have a fiduciary duty to ask and, as a matter of best practice, should ask intelligent questions of management on any proposed merger or other acquisition. The extent of the inquiries should depend upon the experience and track record of the management team in making successful acquisitions and the potential impact of an unsuccessful acquisition.

Best practices

To ask incisive questions, directors must possess a full understanding of the reasons why mergers and acquisitions typically fail and an understanding of the best practices that management should be using. Directors should educate themselves on best practices by reading academic and other literature which analyze the reasons mergers and other acquisitions fail. Directors without significant M&A experience should consider reading such books as Deals From Hell: M&A Lessons That Rise Above the Ashes which carefully examines 10 M&A "train wrecks," as well as relevant academic studies which are freely available on the Internet. The education obtained from these books and studies will permit the board to ask the right questions of management. It also permits the board to determine if outside expertise is necessary to supplement management judgment and implementation tactics in connection with the proposed merger or acquisition.

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Directors should be aware that the most successful deals are with targets in the same or a closely related industry. The worst deals typically occur in "hot" markets. Properly structured "earnouts" are generally associated with successful acquisitions.

Action items

Some of the major reasons cited in academic papers for the failure of mergers and other acquisitions are the following:

Management fails to perform adequate strategic due diligence.

Action Item. Strategic due diligence allows the buyer to question itself in a critical way as to what areas should be emphasized during its financial and operational due diligence investigation. The board should question whether outside expertise is needed by management.

Management fails to understand the customer relationships of the target employees, with the result that significant revenues are lost when key employees leave the target and take customers with them.

Action Item. The Board should question how management determined who the key employees of the target were for purposes of customer retention and request information as to contractual obligations (e.g. non-compete or nonsolicitation of customer provisions) which are being imposed upon these employees as a result of the acquisition.

The failure to perform adequate financial and operational due diligence on the target, including problems in the base business of the target, which ultimately result in failed projections of increase revenues and synergies.

Action Item. The Board should question whether outside expertise is needed and ask questions as to the assumptions of increased revenues, cost savings and other synergies.

The failure to properly integrate cultures of the target with the acquirer.

Action Item. Studies indicate that cultural integration must begin well before closing the acquisition and the board should understand management's proposal to ameliorate this risk. In general, the best practice is to have the same team members who provided due diligence for the acquisition follow-through in the post-acquisition period.

The key to great M&A investing is to learn from the mistakes of others. It is the directors' job to help management focus on the key reasons of M&A failures and to apply the lessons learned to each proposed significant acquisition.

Frederick D. Lipman is a partner at Blank Rome LLP and author of Corporate Governance Beit Practices (John Wiley & Sons, Inc., 2006) and Valuing Your Business (John Wiley & Sons, Inc. 2005).

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