Hewlett Packard Decision Warns Delaware Will Be Tough on Conflicts of Interest

A Delaware judge has fired a warning shot about the deepening potential for conflicts of interest among dealmakers and their advisers. If not exactly the declaration of a zero-tolerance policy, a few well-chosen words in the decision that cleared the way for Hewlett-Packard Co. to acquire Compaq Computer Corp. tipped deals lawyers that Delaware’s influential and closely watched courts could take a tough line in future cases involving conflict issues. As a result, attorneys counseling companies and their advisers on mergers and a wide range of other transactions indicate that they will be intensifying efforts to make sure conflicts don’t arise. They have their work cut out for them, say legal and corporate governance observers, because consolidation in the financial services industry has thrust many institutions into multiple roles on the same deal. The May 2 ruling by Chancellor William B. Chandler III removed the last hurdle to the $19 billion H-P/Compaq merger, which had been bitterly opposed by H-P director Walter Hewlett. After shareholders narrowly approved the deal in late April, Hewlett sued in Delaware, alleging that H-P engaged in improper vote-buying by influencing the Deutsche Asset Management unit of Deutsche Bank to switch some 17 million shares in favor of the deal. In a 42-page decision, Chandler said that Hewlett hadn’t proved his contention that Deutsche caved in to threats of a loss of banking business. But deals lawyers say that the decision has legs because Chandler came down hard on a controversial conference call that triggered Hewlett’s complaint. The conversation between H-P and Deutsche officials preceded the vote shift. Chandler said he was troubled that Deutsche bankers helped arrange the call and that one listened in. He said that the events raise questions “about the integrity of the internal ethical wall that purportedly separates” Deutsche Bank’s asset management unit from its commercial banking operations. The very existence of the judicial tongue-lashing in the basic decision was viewed as a wakeup call. “By putting that in, he’s sending a signal,” says Charles Elson, head of the Corporate Governance Center at the University of Delaware. “He didn’t have to put that in the decision. It’s not necessary for the case. But he’s sending a signal that he was troubled, and if he’s troubled, that certainly has implications for future voting.” When a judge critiques a process, Elson notes, “it’s certainly a reason to be concerned,” and in Deutsche Bank’s case, Chandler questioned whether the wall of separation was “high enough.” “I think that his critique of their procedures is certainly something that one would be wise to consider,” Elson says. “I think it means that the court will focus very intensely on this issue.” William G. Lawlor of the Philadelphia-based Dechert law firm says that he expects “much greater sensitivity” to conflicts, especially since m&a-driven consolidation has reduced the number of commercial banks and most of the big ones have large shareholding asset management divisions. That creates the potential for a situation in which “your underwriter is your banker is your analyst is your stockholder,” he says. “Those four pillars are rife with potential conflicts.” For the legal practitioner, Lawlor notes, the challenge is to make sure that client companies that are dealing with advisers that “wear multiple hats” get their exact roles straight. “When you are talking to your commercial banker, recognize that you can’t be talking to him as a shareholder or you may run into these types of problems,” he states. “So you must be sensitive to the fact that the clients you have relationships with may have different hats. And depending on which they have on may require your conduct to change.” Companies have “to be very careful in dealing with advisers so that they remain just that – advisers,” Elson says. “You cannot put yourself in a position where your actions can be viewed as improperly influencing the vote.” Elson advises that Chandler’s main decision in the H-P/Compaq case be read in conjunction with a previous ruling that cleared Hewlett’s complaint for a full trial. In the preliminary decision Chandler reinforced the principle that vote-buying is off-limits when a company improperly uses corporate assets to coerce how shares are voted. In the end, Hewlett did not produce the smoking gun to demonstrate that happened but Elson said that the initial decision should be read as a firm warning. Although the case directly involved a merger, contested voting, and an instance in which the same institution was a banker and a shareholder, lawyers say that the decision with Chandler’s critique could have ramifications for other conflict-prone situations. For starters, that includes shareholder voting on all types of questions, whether contested or not. There also are possible implications for cases in which a financial institution supplies merger advice, underwrites securities, and issues business loans to the same client, and the mushrooming controversy over buying auditing and consulting services from the same accounting firm. The Securities and Exchange Commission (SEC) is also investigating Hewlett’s allegations under federal securities laws. Lawlor says that other issues raised in the H-P/Compaq might test m&a lawyers in future cases. Notably, Chandler rejected a second Hewlett allegation that H-P management wasn’t candid about problems in integrating the two big firms. Traditionally, Lawlor adds, that issue might have been raised as a failure to make full disclosure under U.S. securities laws. Instead, Hewlett chose to file a state-law claim that H-P managers and directors violated their “duty of candor.” Involved here are the forward-looking statements in proxies and other documents that companies use to project future results, including merger benefits. “There has not been much litigation over the accuracy of these fairly aggressive synergy and revenue and earnings-per-share enhancement statements, largely because they are protected under safe harbor provisions in the U.S. securities laws,” he says. “So this is one of the first prominent cases in which one of the shareholders has challenged it. He didn’t challenge it under federal securities laws. What he said was that there was a state-law duty of candor violation and, therefore, he was going to claim that the entire vote had been polluted.” Although the judge did not specifically address the issue, the Hewlett complaint surfaced the duty of candor issue as an option for dissident shareholders and warned forecasting companies to be wary in relying exclusively on the federal safe harbor cloak. Lawlor says in that connection that the specific issue of integrating the two companies is a cause for legal concern. Chandler noted, for example, that H-P and Compaq got the integration process started before the vote. While an early move is strategically laudable, it can create a legal powder keg if the acquiring company finds something drastically wrong with the target. The dilemma then is whether it should inform shareholders. “The more you do before the vote,” Lawlor notes, “the more you may learn that the information may be wrong, the more you may create duties to update, whereas if you deferred the integration, you wouldn’t get into that problem. You have to be careful about what you find before the vote.”