Corporate governance is an indispensable component of any M&A transaction, and businesses operating in California face unique considerations due to the state's specific legal and regulatory framework. In Part 1 of this two-part series, we will delve into the potential consequences of weak governance, explore the benefits and implications of retroactive ratification, and examine how these concepts apply in the context of M&A deals.
What is Corporate Governance?
Corporate governance means all appropriate internal approvals have been obtained during a company’s history. For a corporation, good governance means that material events receive approval from the board of directors and, when necessary, from the shareholders. Additionally, it involves upholding the provisions outlined in the Articles of Incorporation and the Bylaws, and any other plans or agreements, thereby preventing any violations. Where related party transactions are involved, it can mean setting up a committee of independent directors to review and recommend action. In the case of an LLC, governance means following the provisions outlined in its Operating Agreement. This agreement usually stipulates that certain matters require approval from managers, while others necessitate member approval. The primary purpose of corporate governance is to establish a record of internal approvals of material events, and the reasons those decisions were made at the time.
Approvals, Violations, and Risk
Without proper approvals, previous actions may be deemed invalid or subject to attack by stakeholders. Failure to hold necessary meetings and uphold corporate formalities can also open the door to third-party creditors or claimants to argue that the corporate entity is merely the ‘alter ego’ of the owners. Failure to maintain comprehensive meeting minutes and records of past approvals raises questions about what’s missing.
Consequences of Weak Governance in M&A Transactions
In the context of mergers and acquisitions, the buyer reviews the corporate governance of the seller as part of its due diligence investigation into the business. This inquiry is intended to discover the scope of what’s being bought and identify potential risks and liabilities that could affect the business after the buyer pays for it. If proper corporate governance is not observed in running the business, it begs the question of what other shortcuts have been taken? Corporate governance failures can lead to reduced valuations, delays in closing the deal, increased legal costs, and, in severe cases, jeopardize the sale altogether.
The Benefits and Implications of Retroactive Ratification
In the process of preparing a business for sale, the seller should thoroughly review and rectify any issues with corporate governance. If the current management team, and even the current ownership, don’t have a paper trail showing valid issuance of their shares, as well as valid election and appointment of the directors and officers or managers, it raises concerns over authority to sell the business and deliver clean title to the business and its assets.
While it is possible to ratify many defective or missed approvals and meetings, even many years after the fact, complications can arise when the individuals who were originally involved in those approvals are no longer associated with the company. Additionally, ambiguity or disagreement may arise regarding the specifics of what was approved or what requires ratification. Thus, sellers should follow best practices for corporate governance in real time, at all times. This is the best way to always be ready for potential offers to buy the business.
Correction of Governance Errors in California
Some governance errors have been difficult to fix after the fact, particularly when the error resulted in several other material events that would not have otherwise been approved but for the original mistake. In some cases, stakeholders have been able to invalidate both the original defective action (a board election), and all the following matters that were approved by that improperly elected board (a domino effect of invalid approvals). This year California has implemented a new statutory procedure providing California entities with expanded authority for fixing past mistakes in corporate governance and shoring up the risk of a domino effect of invalid corporate approvals thereafter.
Specifically, California added Section 119 of the California Corporation Code (CCC) which provides a statutory framework to retroactively ratify legally permissible corporate actions that were missing proper approvals or were defective in some manner. Section 119 provides both a self-help ratification process and judicial process. The self-help process for ratifying a defective corporate act requires approval from the current board and, if the act would have required shareholder approval at the time of ratification, consent from the current shareholders. Other actions require court approval. When Section 119 is followed, the error is corrected, and the domino effect of invalid corporate actions is avoided. This typically would not negate lawsuits from aggrieved claimants for damages, but it does address questions of lack of authority and validity of approved actions.
Buyer Focus on Seller's Corporate Governance
Business buyers place significant emphasis on the seller’s corporate governance practices, especially those that may result in liabilities for themselves or future buyers. This is an important part of the due diligence review process. Buyers are mainly looking to confirm there is no one that will ‘come out of the woodwork’ claiming to own part of the company, or some of its assets, or otherwise have standing to assert a post-closing claim against the buyer or the business. In addition, buyers look to confirm the authority of the board and shareholders to approve the sale, and to identify any historical stakeholders that may object to the sale. Solid corporate governance will comfort buyers that neither issue will be a concern. This underscores the critical importance of corporate governance at all stages and throughout the history of a corporation, highlighting the need to engage the guidance of experienced attorneys from the outset. By doing so, businesses can safeguard their interests effectively and avoid delays, expense, and price reductions in a sale caused by inadequate compliance with corporate governance requirements.
Next Up...
In the upcoming Part 2 of this series, we delve further into the California context, exploring additional considerations in M&A control and compliance. We'll discuss understanding California's corporate laws, the role of regulatory agencies, employment considerations, privacy and data protection, compliance with California's Blue Sky Laws, and staying abreast of legal developments. Access Part 2, titled ‘Six Strategies for Ensuring M&A Control and Compliance in the California Context,' to gain valuable insights. If you need assistance in ensuring a seamless and compliant M&A transaction, partner with Adams Corporate Law. As an experienced firm specializing in mergers and acquisitions in California, our expert team is ready to provide the guidance and expertise you need to update your corporate governance responsibilities effectively. Schedule a consultation today at (714) 619-9360.