Anatomy of a Failed MBO (and Ensuing Lawsuit)
The starting point for this story is ACS’s larger-than-life founder and Chairman, Darwin Deason, a four-times married former Arkansas farm boy who reportedly drinks the heinous combination of Diet Coke and Kahlua to self-treat an acknowledged drinking problem and who either did or did not threaten to kill his personal chef on his yacht in September 2001. These colorful personal details, and many more, are described at much greater length in a June 2003 D Magazine article entitled "Lifestyles of the Rich and Shameless" (here), as is this particularly interesting note about an unsuccessful MBO bid that Deason led in 1988, in connection with MTech, a company Deason previously founded:
In 1988, with banks failing all over Texas, MTech’s majority owner MCorp…began to slide toward Chapter 11. Reading the tea leaves, Deason puts together a $360 million management buyout of his firm. As the last second, thought, Plano-based EDS raises its hand and shouts "Four hundred and sixty-five million!" MTech is sold to the highest bidder. Deason is furious. He resigns some 90 minutes into his employment with EDS, apparently walking out before anyone can get him to sign a noncompete agreement….Five months later, with 18 of his top 22 executives from MTech on board, he launches ACS.Having formed ACS from the remnants of a failed MBO in which he was outbid by a competing bidder, it may well be supposed that Deason was determined not to permit himself to be similarly outbid in his attempted buyout of ACS itself.
In late 2006, options backdating allegations put Deason and ACS on the front page of the Wall Street Journal. In a December 30, 2006 article entitled "Living Large and Bouncing Back" (here), the Journal provided further interesting details about Deason’s background, noting, among other things, that "although Mr. Deason, who retired as CEO in 1999 and is still ACS’s Chairman, received two option grants on extremely favorable terms, two internal probes didn’t find evidence that Mr. Deason knew about or took part in any backdating."
The Journal article details ACS’s internal backdating investigations, the second of which resulted in the November 2006 resignation of Deason’s successor as CEO, Mark King, as well as the company's CFO (the company's press release about which can be found here). The Company itself later announced in a January 5, 2007 filing on Form 8-K (here) that it was amending the exercise date of certain option grants, including one grant to Deason. The Company said it was taking the step to eliminate negative tax implications. According to the Journal, these option related issues created tensions between Deason and the independent directors that may have carried over to the circumstances surrounding the MBO.
An options backdating-related shareholders' derivative lawsuit against the company as nominal defendant and against certain current and former directors and officers remains pending (refer here).
In March 2007, Cerberus Capital Management, in conjunction with Deason (who owns 42% of the ACS voting rights, but less than 10% of its ownership by valuation) made a buyout offer that as adjusted was worth $6.2 billion. Cerberus withdrew its offer on October 30, 2007 (refer here), explaining that the withdrawal was "due to the continuation of poor conditions in the debt markets." But while debt market turmoil undoubtedly was the ultimate trigger of the demise, a full-throttle dispute between Deason and the independent Board committee set up to review the offer was a critical circumstance in which events unfolded, and which set the stage for the current public fracas between Deason and the directors.
The dispute between Deason and the Special Committee is dramatically revealed in a series of letters, all of which are now very publicly available. The first letter (here, Exhibit A), dated October 30, 2007, and written by the Kosowitz, Benson, Torres, & Freidman law firm on behalf of ACS’s current CEO, Lynn Blodgett, demands the "immediate resignation" of the five Special Committee members, alleging that they had "totally failed to discharge [their] responsibilities, accusing them of delays that "squandered an immensely valuable opportunity" and having failed to elicit any alternative bids." The letter also accuses the directors of having disclosed "confidential trade secret information" to one of ACS’s direct competitors. The letter concludes by accusing the five individuals of "gross breaches of their fiduciary duties," and states that the Special Committee must be terminated and they must each resign "forthwith."
Deason sent his own letter to the five individuals dated November 1, 2007 (here) in which he said he "most respectfully asks that you resign today from the Board." Deason’s letter also accuses the five of delaying consideration of the Cerberus bid while failing to produce another bidder, as a result of which the Board has "lost shareholder trust." Deason asserts that "changing the membership of the Board is in the shareholders’ best interest." The letter also proposes a slate of "replacement directors." Deason states that "the management of the Company has indicated it may also take action, including potential litigation, in the interests of the shareholders of the Company." Deason concludes by asking the individuals to make the "right choice" and "resign immediately."
The five directors responded in two letters dated November 1, 2007. First, their counsel, Weil Gotshal & Manges, responded to the October 30 letter, in a letter (here, Exhibit B) noting that the October 30 letter is "premised on the remarkable principle that it is management rather than the Board of Directors that is ultimately responsible for the business and affairs of the Company." The Weil Gotshal letter asserts that the delays in considering the Cerberus bid were due to the inclusion in the Cerberus deal of Deason’s agreement to work exclusively with Cerberus, which provision the letter asserts was "designed to and did in fact chill the interest of competing bidders," a provision that Deason refused until June 10, 2007 to waive. The Weil.Gotshal letter asserts that the Special Committee process did in fact result in a higher bidder, but that "management and Mr. Deason worked hard to assure that no buyer would have a full and fair opportunity to obtain the information necessary to make a proposal."
The five ACS directors also sent their own November 1 letter (here) in response to Deason’s letter, in which they assert that they have "acted appropriately and in a manner designed to safeguard the best interests of the company." The directors’ letter recounts the delays occasioned by Deason’s exclusivity agreement, and asserts that "you [Deason] and your management team worked hard to make it difficult for any other buyer to have access." Their letter states that "your interest only in a transaction in which you would participate on the buy side and management’s interest in retaining their jobs" delayed the process.
The directors’ letter goes on to state, with reference to the October 30 board meeting:
Your carefully choreographed power play Tuesday evening to coerce the independent directors of ACS into resiging on the spot is consistent with your continuing refusal to understand that the Board’s fiduciary duties are to all shareholders – not just you. Your ultimatum: resign in one hour or I will go to the press and smear your reputations – was a remarkable piece of bullying and thuggery, and it almost worked.The directors’ remarkable letter goes to state that Deason’s interference with the Special Committee "made it impossible for us to continue to effectively serve as directors." The letter notes Deason’s extraordinary authority in his employment agreement (which apparently gives him the ability to recommend the approval or removal of directors) as well as Deason’s conduct, rendered the individuals unable to "properly discharge" their fiduciary duties. The letter observes that "we could fire you and the entire management team, but that would not help our shareholders, customers or employees. Rather it would rip the Company apart and cause a lengthy fight and a period of uncertainty from which the Company would be unlikely to recover…we have decided …that the best way for us to discharge our fiduciary duties is to resign in favor of a new majority of independent directors." The letter concludes by stating that upon completion of the process of vetting independent director candidates, the five would step down "with great relief."
Having offered their prospective resignations, the five individuals took one further extraordinary step: they filed a declaratory judgment action (here) in Delaware Chancery Court against the company, Deason, Blodgett, and ACS’s current CFO. The not-yet-former directors’ lawsuit, clearly filed as a preemptive strike against anticipated actions by Deason or company management, briefly repeats the assertions from the directors’ November 1 letter, and asks the court to "declare that the Plaintiffs have not breached their fiduciary duties."
There is always a potential for a conflict of interest in a management-led buyout, as I have previously noted (here). The November 2, 2007 New York Times article entitled "A Bitter Rift When the Boss is the Buyer" (here) said that "the [ACS] drama highlights the potential conflicts that can occur when a founder or chief executive leads a deal to acquire a company, something that has become common in the recent wave of leveraged buyouts." One of the most challenging issues that can arise in an MBO is what the Wall Street Journal describes in its November 2, 2007 article "A Failed Deal at ACS Sets Off a Board Brawl" (here) as the "fraught dynamics created inside boardrooms when insiders try to take public companies under private ownership."
But even within the fraught dynamics that characterize these kinds of deals, the ACS tussle is extraordinary. It is pretty clear that the fraught dynamics gave way to open warfare as the two sides sought to establish who was to blame for the deal’s failure. Clearly, Deason’s determination to avoid losing out to a higher bidder, as he lost his 1988 attempt to buy out MTech, seems to be a critical part of many of the events. The topsy-turvy ouster of the independent Board members by company management may perhaps be explained, if not entirely understood, by the extraordinary provision in Deason’s employment agreement that actually gives him the authority to recommend the approval or removal of directors.
The directors for their part were put in a position of struggling against the company’s forceful Chairman while trying to determine whether an alterative to Deason’s bid would be in the sharholders’ best interests. The directors efforts took place under circumstances where shareholders had already initiated litigation (refer here) alleging that management-led buyout provided shareholders with inadequate value and that Deason had misappropriated inside information to secure Cerberus's participation in the transaction.
Ultimately, what doomed this deal was a perverse combination of timing and the changing marketplace conditions. Although Deason eventually waived the exclusivity agreement with Cerberus, that didn’t happen until June, and the waiver only extended for two months. By August, changed conditions in the credit marketplace had greatly complicated ACS’s effort to determine potential interest in alternative buyers, and the Board sought a further extension of Deason’s waiver (about which refer here). But by then, Cerberus itself was having trouble securing financing, and the deal failed. With no prospects left, the finger-pointing began.
The five directors’ declaratory judgment action, in which they sued the very company on whose Board they still serve (at least until their prospective resignations become effective), represents another extraordinary aspect of this unusual set of circumstances. Their attempt to defend themselves preemptively by initiating a declaratory judgment action effectively seeks to enlist the court on their side in their struggle to establish that they are not to blame for what happened.
While the intensity and the public nature of the ACS dispute may be unusual, there likely will be other similar recriminations as changed credit conditions cause other planned deals to fall apart. The "fraught dynamics" may give way to further lawsuits – yet another byproduct of the changed conditions in the credit marketplace. It is probably worth noting in that regard that every aspect of these circumstances -- the backdating allegations, the management-led buyout offer, and the managment dispute with the board -- led to litigation against directors and officers of the company. Just something that every board should keep in mind the next time the topic of D & O insurance comes up. When things go bad, a well-structured D & O program is absolutely indispensible.
The directors’ declaratory judgment action poses some interesting issues from a D & O insurance perspective. The typical D & O policy has a so-called Insured vs. Insured exclusion, sometimes referred to as an infighting provision. While this provision usually has a coverage carveback for shareholders derivative suits, the typical wording contains nothing that would help understand where this lawsuit might fit. It would be hard to characterize these circumstances as anything other than "infighting."
Hat tip to the WSJ.com Law Blog (here) for the links to the letters and to the directors' complaint.
UCLA Professor Stephen Bainbridge has detailed analysis of the ACS "soap opera" on his Business Associations blog (here), including a discussion of relevant Delaware case law.
Bonfire of the Historical References: There was a real temptation in writing this post to refer to the title of Tom Wolfe’s wickedly funny book, The Bonfire of the Vanities. Although Wolfe’s title seemed perfectly apt for his book and, by extension, to this post, the book title is in fact a misplaced historical reference. The phrase "Bonfire of the Vanities" does not refer to a titanic conflagration of egos, but instead refers "the burning of objects that are deemed the occasion of sin" (according to Wikipedia, here), the most famous of which was the February 1497 burning of luxury objects by supporters of Savonarola (pictured above) in Florence, Italy. The phrase was undeniably a great title for Wolfe’s book, but a perhaps overactive desire to avoid historical infidelity constrained me from using the phrase in this post, much as it seems to fit the circumstances at ACS.