When Management's Best
Guesses Fail, Boards Can Too
By Liz Hoffman
Law360, New York (April 12, 2013, 8:34 PM ET) -- Predicting financial
performance is tricky. Each quarter, dozens of companies fall short of
expectations, while a lucky few sail past them. Investors grumble,
executives promise to do better and everyone lives to fight another
But when a company is for sale, management's inability to come up with
accurate figures isn't just annoying to shareholders and analysts. It's a
potential legal nightmare for boards of directors tasked with overseeing
the process, attorneys say.
Buyouts offer a stark choice. Boards must decide, on behalf of
shareholders, whether a cash payout today is worth more than the company's
future earnings. But when those projections are changing by the week, that
job quickly gets tough.
"The board is there to oversee the process, and they're relying on
information given to them by management," said David Grinberg, who heads Manatt
Phelps & Phillips LLP's mergers and acquisitions practice. "If
the board can't trust the numbers, it's going to be very difficult to come
to a recommendation they feel comfortable with."
Consider the current situations of Dell
Inc. and Billabong Ltd.
Dell's board has been evaluating a go-private offer from its founder
Michael Dell and private equity firm Silver Lake Partners since August.
The buyers first offered between $11.22 and $12.16 per share, leaving the
board to weigh that cash payout against the potential earnings of a public
Dell, or some alternative transaction like a dividend or asset sale.
The problem, according to the proxy statement released last month is that
the board couldn't get reliable management projections. In July, just
before Michael Dell approached the board, the company's revenue estimate
for the current fiscal year was $66 billion. In September, it was revised
to $59.9 billion. By March, it was down to $56 billion, a full 15 percent
off its original estimate.
The quarterly earnings were no better. In August, the company missed its
own guidance by $300 million. In November, it missed by $260 million.
JPMorgan Securities LLC, the investment bank advising Dell's special
committee, gave a presentation showing that Dell had missed its revenue
mark for seven straight quarters and another suggesting the best-case
scenario that had Dell's stock reaching as high as $21.75 was "aspirational
in nature," not to be taken seriously.
Dell's special committee eventually brought in an external adviser, Boston
Consulting Group, to recrunch the numbers. BCG returned with an
operating profit forecast that was 16 percent below management's, a net
income estimate 26 percent lower and a free cash flow estimate 36 percent
lower, using the high end of each range.
That suggests one of two things: Either the company's fortunes were
changing so quickly that management couldn't keep up, or Dell's executives
were too optimistic. Either way, Dell's directors didn't like it.
The management forecasts were “not particularly helpful in assisting the
special committee in evaluating the company’s alternatives to a sale
transaction because of the special committee’s belief that some of the
assumptions underlying the projections were overly optimistic," the proxy
In other words, the board couldn't trust management's projections. That's
a problem, said Jack Hardin, a founding partner at Rogers
& Hardin LLP. Management can lose credibility with directors,
and directors, fearful of shareholder backlash, can take a firmer stance
on other points, he said.
"Anytime management puts out something that creates an expectation and
that expectation does not hold up, it makes negotiations more difficult,"
said Hardin, who declined to comment on the Dell case, but spoke more
generally about special committees. "The later in the process it happens,
the more problematic it is for a smooth and efficient negotiating
The most important thing, especially in a conflicted transaction, is to
show that the board looked closely at the numbers, attorneys said. Even
management with a history of hitting its marks should get a closer look,
said Jeffrey Patt, who heads Katten
Muchin Rosenman LLP's M&A group.
"If management comes to a board with a [discounted cash flow] model and
says 'the number is $17 per share and here's how I got there,' the
question should not simply be whether $17 is the right number, but whether
the underlying assumptions are the right assumptions," Patt said. "A
well-counseled board generally shouldn't accept projections on faith."
Billabong, the Australia-based clothing retailer, offers another example
of the perils of inaccurate projections. Private equity firm TPG
Capital offered to buy Billabong for AU$3.30 per share, or
about AU$694 million, in February 2012. But founder Gordon Merchant said
his company was worth AU$4 per share, and his board backed him up.
Since then, the company has repeatedly cut its financial forecasts.
Shortly after turning down TPG, Billabong took a AU$567 million write-down
and cut its profit forecast by $9 million. In June, it lowered its
forecast for 2012's full-year earnings before interest, taxes,
depreciation and amortization by more than AU$20 million, or about 13
Against this shifting sea of projections, the company's board of directors
has been tasked with evaluating four private equity bids, whose prices
dropped with each downward revision. This week, Sycamore Partners LLC
appears to have won out, but at just 60 cents per share.
More broadly, this issue can land companies and their boards in legal
trouble, especially in situations with a large insider. In 2006 litigation
over the buyout of Emerging Communications Inc. by its chairman and CEO,
the Delaware court held that the executive's withholding of accurate
financial advice from directors “was enough to render the special
committee ineffective as a bargaining agent for the minority
While the circumstances here are different — no one has alleged that
either Dell's or Billabong's projections were willfully inaccurate — the
principle still applies: Boards need accurate financial data to do their
Sorting through shaky projections is tough, but it's only half of that
job. The other half is disclosing it in a way that passes muster with
regulators and judges. When boards see several sets of financial
forecasts, some rosier than others, which ones are shareholders entitled
to know about?
The letter of the law is clear: Boards must disclose the specific
projections they used to make their recommendation. But its spirit can get
fuzzy, Hardin said. Did other projections subconsciously seep in? Does the
mere fact that the board received multiple sets of numbers matter? Did the
board ask why they were different?
Dell, for example, disclosed two separate sets of internal management
projections as well as BCG's external numbers, and its proxy statement is
packed with data, as well has a half-dozen presentations, reprinted
verbatim, from its investment bankers at JPMorgan andEvercore
"When there are a lot of numbers floating around, the question arises as
to whether everything is fair game for the proxy," Hardin said. "You have
to evaluate what you disclose about the process — what are the key points
and the key steps."
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