A Sure Thing Versus the Peak Price: Courts take a real-world view on this historic balance

Following the Delaware Supreme Court’s 2003 decision in Omnicare Inc. v. NCS Healthcare Inc., the use of deal protection devices by companies in mergers and acquisitions unmistakably suffered a setback, and the rules under which these defenses operated became unclear. In addition, the court seemingly changed the rules surrounding the use of protection strategies in merger agreements to reduce their potency. Perhaps the court’s most surprising modification to these rules came in its conclusion that a board’s good faith decision to agree to deal protection devices would be subject to judicial review with the benefit of hindsight. However, the Delaware Chancery Court decisions in Orman v. Cullman, issued in 2004, and In Re Toys “R” Us Inc. Shareholder Litigation in 2005 offer some clarity on the rules regarding the use of defensive devices after Omnicare. They suggest that there are real-world conditions that make deal protection devices acceptable. These decisions also provide guidance on when a board of directors employing a defensive strategy to protect a transaction will be penalized for violation of fiduciary duties. Most important, these decisions appear to have limited the damage to deal protection devices caused by the Omnicare ruling. Companies utilize various defensive devices and strategies in merger agreements to deter third parties from attempting to interfere with their ability to consummate the deals and to provide reasonable compensation to the initial bidder if its bid is topped. Nevertheless, defensive devices should not effectively prohibit nor make unduly expensive a third-party bid that could prevent stockholders from maximizing the value of their investment. Among the most familiar deal protection devices used by companies are: * “No shop” clauses, which prohibit a target’s board of directors from soliciting or encouraging higher bids from third parties after execution of a deal agreement; * Termination or breakup fees, which are designed to reimburse the initial bidder for its expenses related to the cost of preparing and making the offer if another bidder usurps the deal. The fee often includes an additional payment representing lost time and opportunity; * Voting agreements, in which significant stockholders agree to vote in favor of the proposed deal; and * The absence of a “fiduciary out” provision, the omission of which prohibits the target’s board from considering subsequent offers, even if they are higher than the original bid. The Omnicare case was rooted in a merger agreement between NCS Healthcare Inc., a financially troubled company, and Genesis Health Ventures Inc. that included three defensive mechanisms designed to protect the agreement and make it more difficult for other third-party bidders to “jump” the deal in an attempt to acquire NCS. They included: * A “force the vote” provision requiring NCS directors to submit the agreement to a vote of its stockholders, regardless of any change in the board’s recommendation regarding the proposed transaction; * The absence of an effective fiduciary-out clause, the exclusion of which meant that NCS’ board could not negotiate with other potential buyers whose offers could have resulted in a superior bid; and * Voting agreements requiring two NCS stockholders who owned approximately 65% of the stock to vote in favor of the deal, notwithstanding any change in, or withdrawal of, the board’s recommendation. After NCS’ board approved the merger, Omnicare Inc., another major health care firm, made a superior offer. NCS’ board exercised its fiduciary duties and recommended that its stockholders vote against the merger with Genesis. Nevertheless, the package of deal protection devices ensured that the merger agreement with Genesis would be submitted to a stockholder vote and mathematically guaranteed that the merger would be approved. In a suit filed by Omnicare to prevent consummation of the Genesis/NCS merger, the Delaware Supreme Court, in a 3-2 decision, subjected the defensive mechanisms to enhanced scrutiny under a Unocal standard of review, aimed at determining fairness to all shareholders, and overturned the Chancery Court decision. The Supreme Court concluded that the defensive mechanisms were invalid and unenforceable because, acting in concert, they fashioned a protective scheme inconsistent with the ability of NCS’ directors to properly exercise their fiduciary duties. Furthermore, the defensive devices made it mathematically impossible for NCS’ stockholders to reject the Genesis merger, which, in turn, made it realistically unattainable for Omnicare’s bid or any other third-party proposal to succeed, no matter how superior the offer was. The Omnicare decision appeared to depart from Delaware’s business judgment rule and create a new “rule of the game” under Delaware M&A law. In fact, the dissenting opinion characterized this new rule in the following manner: “A merger agreement entered into after a market search, before any prospect of a topping bid has emerged, which locks up stockholder approval and does not contain a fiduciary-out provision, is per se invalid when a later significant topping bid emerges.” M&A experts feared that the “new rule” would preclude a seller’s ability to trade deal certainty for a higher price and could have a deterrent effect on dealmaking activity, because the “universe of potential bidders who could reasonably be expected to benefit stockholders could shrink or disappear.” Deal certainty itself often enhances value for the target and its stockholders in several ways. First, a buyer may pay a higher price for the target if the buyer is guaranteed that the merger will be consummated. Second, certainty prevents the target from losing its buyer and possibly creating a perception that the target was tainted goods. That could reduce the value that the stockholders would receive in a subsequent transaction. Third, in exchange for deal certainty, buyers often agree to limit their own “outs” or escape provisions that would prevent deal consummation. As a result, the court’s decision limiting the target’s ability to trade deal certainty for a higher price may have had the unintended consequence of reducing, rather than increasing, stockholder value. The majority of the Omnicare court evaluated the reasonableness of the NCS board’s decision to execute a merger agreement containing defensive measures without considering the unique circumstances and conditions surrounding the Genesis/NCS negotiations and the financial distress of NCS. Rather than evaluate the defensive provisions in the context of the entire bidding and negotiation process to determine whether NCS’ board informed itself of all available options and whether the board acted in good faith in accordance with its fiduciary duties, the court reviewed the protective provisions in a vacuum. Certain situations exist, however, in which business realities demand a lockup so that wealth-enhancing deals may proceed. Given the fact that the company was on the verge of bankruptcy, NCS was arguably in such a situation. Finally, and most critical, the Supreme Court concluded that a board’s latitude in using deal protection devices varies according to the degree to which stockholders would benefit or be harmed by the value or terms of a competing bid submitted after execution of the initial agreement. The practical difficulty of this type of balancing test is obvious. A board cannot know when it adopts defensive devices whether it will receive a competing bid and what the terms will be. The balancing test permits a court to play the role of a Monday morning quarterback through the “judicial invalidation of negotiated contractual provisions based on the advantages of hindsight.” A board’s good faith decision must be subject to a review of the facts and circumstances that existed at the time the decision was made and not a review in light of post-decision events that were unforeseeable. After the Omnicare decision, companies attempting to utilize protective devices needed to be more conservative in planning and executing their defensive strategies. Undoubtedly, the outcome of the case also emboldened target boards to reject “force the vote” provisions when significant proportions of their shares were committed to vote in favor of the deal. Most disturbing, though, was the fact that the Omnicare court’s reasoning and conclusion created uncertainty and ambiguity as to the precise level at which protective strategies could be used by parties to a merger agreement. Omnicare’s First Application In Orman, the first case to apply the rules of Omnicare in any significant degree, Swedish Match AB agreed to acquire General Cigar Holdings Inc., a company controlled by members of the Cullman family. Pursuant to a voting agreement, the Cullman family agreed that they would vote their shares in favor of the merger and, if the deal did not go through, against any alternative acquisition proposal for a period of 18 months following termination of the merger agreement. The agreement: * Permitted General Cigar’s board to entertain unsolicited proposals from other potential buyers if directors concluded that competing offers would be more favorable to the public stockholders than Swedish Match’s proposal; * Allowed the board to withdraw its recommendation of the merger if it concluded that its fiduciary duties required such action; and * Required that the merger could not occur without the approval of a majority of the minority public shareholders. The merger agreement did, however, contain a “force the vote” provision and did not permit the board to terminate the agreement to accept a superior proposal. A minority stockholder of General Cigar sued, alleging that the company’s board breached its fiduciary duties because the defensive mechanism coerced the public stockholders to vote in favor of the merger. In upholding the merger agreement, the Chancery Court declared that the plaintiff’s argument that the Omnicare ruling applied was misplaced, because the facts and circumstances in Orman differed from those in Omnicare. Most notably, the protection scheme employed by General Cigar did not mathematically guarantee that its stockholders would approve the transaction. In other words, a change of heart by General Cigar’s board could have had a meaningful result because of the board’s fiduciary out and because a majority of the nonaffiliated public stockholders had power to reject the deal on its merits. An interesting, somewhat puzzling, and often ignored aspect of the decision was the court’s conclusion that the 18-month lockup was reasonable and not coercive. This conclusion hinged on the absence of other deal defenses and the buyer’s understandable concern about deal costs and market uncertainties. The court also determined that the 18-month lockup did not coerce minority stockholders to vote in favor of the deal for reasons unrelated to the merits and value of the transaction. To substantiate its point, the court contrasted the lockup to a situation in which fiduciaries threaten stockholders that they must vote in favor of a deal. Under Delaware case law, fiduciaries cannot threaten stockholders in a way that causes their votes to turn on factors beyond the merits and value of the deal. The question, therefore, arises as to whether a lockup that prohibits majority stockholders from voting in favor of another deal for 18 months could constitute a form of threat to the minority public stockholders. In other words, the implicit message from Swedish Match and the majority stockholders to the minority public stockholders appeared to be the following: “You have the right to reject the present deal through a majority of the minority approval requirement. But if you do not approve the merger, the company will not be able to consider another deal for at least a year-and-a-half because the majority stockholders are locked up until the end of that period of time.” Because of the majority-of-the-minority approval requirement, the defensive devices did not preclude another deal but the 18-month lockup certainly may have made that protective strategy coercive. The Chancery Court downplayed the potential consequences of the 18-month lockup because there was no other bidder when the merger agreement was executed. Furthermore, the court indicated that if a third party emerged to bid for General Cigar, the company could let the deadline pass and enter into another deal at that point. Nevertheless, this seems like an impractical alternative in the fast-paced M&A world. An 18-month freeze on the target’s availability could force a company that might become a competing bidder to quickly lose interest in a possible deal. An 18-month period is a substantial amount of time in the corporate life cycle, especially for a company in the tobacco business. In addition, there is questionable validity of the court’s assumption that an 18-month delay would not be a significant cost that could have coerced the stockholders to vote in favor of the deal even if they considered the intrinsic value of General Cigar to be greater than the Swedish Match offer price. It was impossible for the court to know whether the stockholders were only influenced, and not coerced, by the 18-month lockup and that they were truly “free” to reject the deal. The court stated that nothing in the record suggested that the lockup had the effect of causing General Cigar’s stockholders to vote in favor of the deal for some reason other than the merits of the deal. Of course, nothing in the record suggested the opposite either. Another problematic issue is that the court did not address whether an 18-month lockup would always be permissible and under what circumstances it would become coercive. Companies are left without a clear idea of how long and how limiting lockups can be before they become coercive. It also remains unclear under what set of circumstances lockups are permissible. Utilizing Defensive Strategies After Orman A key difference between the Orman and Omnicare decisions is that the defensive strategy employed in the NCS/Genesis merger agreement guaranteed stockholder approval of the deal, while stockholder approval was not mathematically certain in the Swedish Match/General Cigar agreement. One, therefore, can infer that protective devices are acceptable in deals for a company that has majority stockholders, but the scheme cannot go as far as completely guaranteeing stockholder approval. The Orman decision also seems to suggest that the target’s board does not always have to retain the power to terminate the merger agreement itself if the minority stockholders have the right to reject the merger on advice by the board. Also, Orman is the first case in Delaware addressing the length of lockups that prohibited votes in favor of alternative deals. As a result, some experts argue that the case provides at least some comfort that a lockup period of 18 months will not be deemed unreasonable per se. Nevertheless, the decision does not offer meaningful guidance for analyzing the reasonableness of specific defensive devices. Nor did the court compare the relative coerciveness of various deal protection strategies. Another interesting aspect of the Chancery Court’s decision is the conclusion that General Cigar’s board had a meaningful fiduciary-out clause. The fiduciary-out provisions in Omnicare’s and in Orman’s merger agreements were essentially the same. Each allowed the board to change or withdraw its recommendation, although neither allowed directors to terminate the merger agreement nor pursue or accept a competing bid. Therefore, the true fiduciary out in Orman was not created by the fiduciary-out clause in the merger agreement and, in fact, had little to do with the board itself. Rather, the fiduciary out was the ability of the minority stockholders to reject the deal whether the board recommended it or withdrew its recommendation. Toys “R” Us Shareholder Litigation In Toys “R” Us, the Chancery Court further restricted the scope and application of the Omnicare decision. It concluded that a board’s decision to include defensive devices in a merger agreement should be evaluated on a real-time basis and in light of the circumstances and conditions that existed at the time of the decision. Toys “R” Us Inc. agreed to be acquired by an investment group led by Kohlberg Kravis Roberts & Co. for $26.75 per share in cash – a 123% premium over the stock price – when it announced it was examining strategic alternatives. The merger agreement contained four defensive devices: * A termination fee of $247.5 million payable by Toys “R” Us if it abandoned the merger agreement and signed another deal within a year of the first contract; * An agreement by Toys “R” Us to pay up to $30 million in documented expenses after a “naked no vote” – a situation in which stockholders vote to reject the merger but the vote was not followed by the acceptance of an alternative deal; * A no-shop provision that precluded the toy retailer from continuing to seek a buyer but permitted the consideration of unsolicited bids; and * KKR’s right to match a superior offer within three business days. Shortly before the stockholder vote, a group of Toys “R” Us stockholders sued to enjoin the vote, alleging that the board breached its Revlon duties for various reasons, including its inclusion in the merger agreement of deal protection measures that precluded the emergence of a superior bid. Under its 1986 Revlon decision, the Delaware Supreme Court determined that in certain limited circumstances a board, in selling the company, has a duty to seek the deal offering the highest value for stockholders. Even though the plaintiffs admitted that the board retained some flexibly to consider a higher offer, they argued that the “cumulative effect of the termination fee and the matching rights created an unreasonably large bidding advantage for KKR that dissuaded any other bidder from presenting a topping offer.” Following an exhaustive factual analysis, the Chancery Court concluded that the board’s decision to agree to the defensive devices was reasonable. The court confessed, however, that defensive devices in merger agreements provided a bidding cushion for merger partners, which works against competing bidders willing to top the initial agreement by only a small amount. Despite this admission, the court said that three significant circumstances precluded judicial intrusion: * The bidding cushion resulted from the actions of a well-informed board acting in good faith and with due care; * The cushion was the result of good faith negotiations in which Toys “R” Us reasonably granted the protective provisions to obtain a good result for the stockholders; and * Despite the cushion, a serious bidder could still present a materially higher competing offer. Most experts agree that the court’s decision in Toys “R” Us was neither groundbreaking nor astonishing. Nevertheless, the ruling contains some important insights and messages concerning the state of deal protection devices in a post-Omnicare world. The court said it “must attempt, as far as possible, to view the question from the perspective of the directors themselves, taking into account the real-world risks and prospects confronting them when they agreed to the deal protections.” In that statement, the court endorsed the conclusion in the Orman decision that a board’s good faith decision should be subject to a real-time review, while rejecting the Omnicare ruling that allows the judiciary to assess the board’s actions in hindsight. The key phrase, “when they agreed to the deal protections,” all but invalidates the court’s role as a Monday morning quarterback. Rather, in its analysis, the court said it should decide whether the board acted reasonably based on the circumstances facing it at the time it acted instead of being judged in light of subsequent events that could not be foreseen. Had the Supreme Court applied this philosophy in the Omnicare case, it’s fairly safe to assume that Genesis/NCS merger would have become a reality. The Chancery Court also recognized that an examination of deal protection strategies in a merger agreement should scrutinize whether the target board had a reasonable basis for acceding to the buyer’s demand for defensive devices in the agreement. This principle is contrary to the Supreme Court’s conclusion in Omnicare, which automatically invalidated any deal protection strategy that completely locked up the deal and made stockholder approval a mathematical certainty, regardless of specific and unique circumstances and conditions existing at the time the agreement was executed. In that context, the NCS board’s decision to completely lock up a deal with Genesis looks not only reasonable but also in the best interests of stockholders. NCS faced severe financial distress, the lack of an alternative competing offer, Genesis’ demand for specific defensive devices, and the likelihood that any bid from Omnicare would have stringent conditions attached. In addition, the court in Toys “R” Us recognized the value of deal certainty to both the buyer and the target. The court rejected the plaintiff’s argument that the board made an unreasonable decision to accept more deal protection in exchange for the certainty of receiving $26.75 per share. After a mathematical analysis, the court concluded that if the board had held out for its original request for a 3% termination fee, it would have risked losing KKR’s offer (which was $1.50 per share higher than any other bid) simply to reduce the cost of the termination fee to another bidder by 20 cents a share. Paying 20 cents a share for increased deal certainty that guaranteed an additional $1.50 per share for stockholders enhanced stockholder value. The court concluded that the board’s decision not to risk the $26.75 per share price offered by KKR “in order to drop a second bidder’s marginal costs to an even slighter level does not appear to deter bids.” Furthermore, the court indicated its confidence in the notion that a combination of a matching right and a termination fee in a merger agreement is not unusual and does not deter an aggressive bidder from paying a higher price. The court reminded the plaintiffs that each is a common contractual feature that is legally sound when used by a board to secure a high bid for the stockholders. The court cited several deals in which a third party repeatedly bid for a target despite the existence of matching rights and a termination fee. As a result, the court concluded that even though the combination may prevent some third-party bids, the defensive strategy did not violate Delaware law because “it is not the concern of our law to set up a system that promotes endless incremental bidding.” Prior to the Omnicare decision, most experts believed that a complete lockup of a deal would not necessarily constitute a breach of directors’ fiduciary duties, especially when the merger premium was significant and there had been extensive shopping of the target prior to the signing of a definitive agreement. Not only did the Delaware Supreme Court seem to dispel this notion but also the justices concluded that a board’s latitude in using defensive devices varied according to how much stockholders gained or lost by a subsequent competing bid. In other words, a board’s good faith decision to accept defensive devices would be subject to judicial review with the benefit of hindsight. Even though the ruling in Orman arguably went too far in certain aspects, the Chancery Court provided some clarity on the rules regarding the use of defensive devices. Still better, the court’s Toys “R” Us ruling strongly expressed the principle that a board’s good faith decision on the use of defensive devices should be subject to a real-time review and should consider the real-world risks and prospects confronting directors when they agreed to the deal protections. Mark Kelson is a Partner, and David Grinberg an Associate, at Manatt, Phelps & Phillips in Los Angeles (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com