The dismissal of the anti-trust litigation against Watchguard and private equity funds Vector Capital and Francisco Partners got all the headlines (here, here, here) a couple of months ago, but a recently filed amendment to the lawsuit over directors’ breach of fiduciary duty makes much more fascinating reading than the somewhat dry anti-trust case. It is also likely to be another milestone in the unraveling of the private equity bubble, because it illustrates to what lengths some managers were able to go to do buyouts on their terms and not in the best interest of shareholders.
It appears that most commentators only read a client alert posted by defendants’ counsel, law firm Wilson Sonsini (NB: some of Wilson Sonsini’s competitors actually posted more insightful comments – our favorite is here, an overview of the others here). Wilson Sonsini conveniently neglected to mention that judge Jones instructed plaintiffs to resubmit the complaint for the two other issues: breach of fiduciary duty and insider trading. And the recently amended complaint contains some juicy details about the Watchguard buyout based on revelation of not just one but two former EVP-level executives turned whistleblowers.
Even a casual observer noticed that something was amiss in the buyout process: shareholders found out about the existence of a proposal not from management, but from a 13D filing by Vector Capital in March 2006. At that time, the company had already been discussing a sale with a number of potential buyers for almost one year. According to a person familiar with Watchguard, one of the obstacles to a sale of the firm was CEO Edward J. Borey’s insistence that he remain CEO afterward. In order to cement his position, Borey had his compensation package amended with a golden parachute amounting to 18 months of pay, and had his underwater stock options repriced. New options replacing the old ones were structured so that the strike price was set to the average trading price before their exercise. In other words, a risk free license to print money whenever the stock jumps. In addition, Borey had the board adopt a poison pill in order to prevent any suitor acquire shares in the open market after learning that Vector planned to do just that. Shareholders were left in the dark that all this was happening against the background of acquisition interest, and Watchguard even claimed in a press release about the poison pill that it was “not currently aware of any attempts to acquire control of the Company.”
Meanwhile, the board of directors was asleep at the wheel. Borey managed the process almost by himself and made it clear to potential acquirers that he wanted to remain CEO. This ruled out a merger with strategic buyers and left only private equity firms in the race. In light of these restrictions, Judge Jone’s assertion that “lack of interest” was the reason for the low buyout price is somewhat naïve. It is alleged that Borey even went so far to withhold the letter sent by Vector Capital from the board. It had been received at a fax machine near the executive office, and Borey simply held on to it and did not inform the board of subsequent meetings with Vector. Even after Francisco Partners entered what was quickly becoming a bidding war for Watchguard the board did not get involved. Instead, Borey continued to drive the sales process and obtained a promise from Francisco Partners that he would remain CEO after the sale. Probably as a result of this concession, Francisco Partners lowered its bid from $5.00 per share to $4.60, and shortly thereafter to $4.25 per share. In the meantime, Vector also decreased its bid to $4.65/share, still a premium to Francisco Partners’ proposal, but the board of directors nevertheless agreed to to the even lower $4.25 bid favored by Borey. It is alleged by one of the whistleblowers that other bidders were also making proposals at higher prices than $4.25, but the board followed Borey’s preference blindly.
It appears to us that the board will have a hard time to justify how it fulfilled its fiduciary duty to shareholders. As one observer pointed out, the impact of the anti-trust dismissal should not be overestimated. There are plenty of other problems in this buyout to keep litigators busy for some time, and eventually provide shareholders with an additional payout.
Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which held shares of Watchguard through the merger.