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By Ronald Fink
Recent court rulings could make it easier for corporate boards to undertake deals without the help of investment banks, according to an attorney who helped argue one case. And he says the rulings could be followed by similar cases at a time when capital markets are unfriendly to initial public offerings and tough on highly leveraged companies.
In a case involving KOR Electronics, a privately held defense electronics firm, the superior court of Orange County, Calif., held on February 25 that its board acted properly in approving a recapitalization despite the absence of a fairness opinion from an investment bank.
Such opinions commonly help corporate directors and managers convince courts in cases brought against them by shareholders that they have acted in good faith and thus qualify for legal protection under the so-called "business judgment" rule.
But KOR went ahead with a recap without getting an investment bank's fairness opinion and succeeded in getting the court to side without it, nonetheless. The plaintiffs -- current and former employees who held the firm's common stock -- argued the recap rewarded KOR's preferred shareholders at their expense, as they had hoped instead for an IPO or sale. The company originally had expected to go public, but found it could not do so at a fair price given prevailing market conditions.
Instead of hiring an investment bank to evaluate the recapitalization against other alternatives, the company relied largely on the ability of its CFO, Thomas O'Hara, to show that the recapitalization was fairer to common shareholders than the most likely alternative, a buyout by a private equity firm.
In the transaction, the company repurchased the preferred shares bought mostly by venture capital investors between 1987 and 1994 for $40.3 million in cash and $9 million in promissory notes, and sold new preferred stock for $40.3 million to new venture capital investment groups.
The plaintiffs asserted that the recapitalization paid an unreasonably high price for the preferred stock and, in effect, wiped out the equity value of their common stock - claiming violation of fiduciary duty, constructive fraud, gross mismanagement, waste of corporate assets, and unjust enrichment. They cited the lack of a fairness opinion from an investment bank as evidence for their claim.
But O'Hara helped show that the most likely alternative to the recap, a PE buyout, would have been more expensive and less likely to produce value going forward for common shareholders.
Under the terms of the recap, KOR would not have to pay dividends for two years, and they would accrue during that interval only if approved by the board. Additionally, the interest rate on the promissory notes was 4 percent.
In contrast, the one transaction of the two proposed by PE firms that had progressed furthest would have obligated KOR to pay annual dividends on a quarterly basis starting immediately. And the rate on the promissory notes that KOR would have been required to issue to the PE firm would have been 8 percent. Moreover, the deal didn't specify how the proceeds of investments would be used.
Robert Brownlie, a partner in the San Diego office of law firm DLA Piper who represented KOR, said that the ability of O'Hara and a board member who was a VC investor to model the terms of the deal was critical to KOR's success in convincing the court that the recap was superior to the potential PE deal.
"They ran different models and scenarios of the transactions in question, with various changes in assumptions," Brownlie explained.
In particular, said Brownlie, O'Hara was able to show that the PE deal would "take all the free cash flow out of the company and not leave enough to fund its continued growth."
In the end, added the lawyer, "we demonstrated that the board acted in good faith and got the protection of the business judgment rule."
Brownlie said more such deals were likely, given current market conditions. In a similar case decided last July, the Delaware Chancery Court ruled in favor of the board of Trados in a sale where the proceeds of the now-defunct company were insufficient to reward anyone but preferred shareholders. The Trados board also had proceeded without a fairness opinion.
Still, Brownlie cautioned that considerable expertise was required of boards and CFOs to proceed without one.
In KOR's case, he said, "The CFO knew it was an issue" well before the deal was done.
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