In In re Netsmart Technologies, Inc. Shareholders Litigation, C.A. No. 2536-VCS (Del. Ch. Mar. 14, 2007), Vice Chancellor Strine held that the shareholder plaintiffs demonstrated a probability of success on the merits of their claim that the Netsmart board of directors failed to fulfill their Revlon duties in considering and approving a cash sale of the company to two private equity firms.  The Court determined that the board’s decision not to conduct a broad market canvass for strategic acquirers, and instead focus the search for acquirers solely on private equity firms, did not appear to be reasonable under the circumstances.  The Court also held that the post-signing “market check” recommended by the company’s financial advisers was not appropriate for a small-cap company like Netsmart, thus was far too passive to have been effective in mitigating the narrowness of the pre-signing market canvass.  This decision provides guidance to boards when considering a sale to a private equity firm — an increasingly common situation affecting boards of directors of public companies throughout the country.

Netsmart is a small-cap company listed on NASDAQ.  Formed in 1992, it grew to be the largest company in its business sector:  behavioral healthcare information technology.  Starting in the late 1990s and continuing through 2005, the company and its financial advisers, William Blair & Co., made “sporadic” attempts to solicit interest in a sale of the company to a strategic acquirer.  None was successful.

In May 2006, following expressions of interest by private equity firms, the board formed a special committee of independent directors.  The special committee, working closely with management and William Blair, decided to focus on the sale of the company to a private equity firm.  The special committee sought out seven private equity buyers, generating competitive bids from four of them.  The committee ultimately recommended a merger agreement with one of the private equity firms, with the entire Netsmart board approving.  The merger agreement contained a “window shop” provision that allowed Netsmart to consider, but not actively seek out, an unsolicited “superior proposal” and a 3% termination fee.

Within days of the announcement of the acquisition, stockholders sued to enjoin the transaction.  The plaintiffs alleged that the sale process was critically flawed, arguing that the Netsmart directors breached their Revlon duties.  In Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), the Delaware Supreme Court held that when a board decides to sell, break up or transfer control of the corporation to an acquirer, the directors assume a fiduciary duty to make reasonable efforts to obtain the highest price for the stockholders’ benefit.  In Netsmart, plaintiffs argued that the board failed to do a reasonable job of obtaining the highest price from the limited universe of private equity bidders it sought out and did not act reasonably in failing to conduct a canvass of all possible strategic buyers, not just private equity firms.

Although the Court criticized the special committee for including management too closely in the diligence process and negotiations with the private equity firms, the Court ultimately concluded that this did not appear to have adversely affected the special committee’s negotiations with the prospective acquirer.  Instead, the Court found that the special committee proceeded in an appropriate price-driven manner.

However, the Court did find a probability of success on the merits of plaintiff’s claim that the board’s and committee’s sole focus on private equity firms violated the directors’ Revlon duties.  The board’s decision not to explore strategic buyers, the Court observed, "was cursory and poorly documented at best," and "hardly the stuff of a reliable market check" that would be expected under the circumstances.  The Court found this was particularly inadequate considering the dynamism of and changes in the business world since the company’s prior market canvass during the late 1990s and early 2000s.  The Court also rejected the board’s argument that the “window shop” provision in the merger agreement provided an adequate, implicit post-signing market check.  The Court held that although such a passive process may be adequate with large-cap companies, it is not appropriate when micro-cap companies are involved.  And while the Court found no evidence that management consciously pursued objectives at odds with getting the best price, there was a basis to perceive that management favored the private equity route over the strategic route because a larger strategic buyer would not be as likely as a private equity firm to retain the same management.

Finally, in addition to their Revlon claims, the shareholders also argued that the proxy statement distributed in advance of the shareholder agreement was deficient for failing to disclose certain management predictions.  The Court held that the proxy statement was rendered materially incomplete because it failed to include all of the projections used by the board’s financial advisor in preparing its discounted cash flow valuation.  In the end, the Court enjoined the stockholder vote until such time that the proxy statement was amended or supplemented to add this additional information.  The parties will continue to litigate the underlying Revlon claims after the stockholder vote.

For further information, please contact John Stigi at (213) 617-5589.