Is a Deal Ever in the Bag?

Dealmakers recently got some bad news from the Delaware Supreme Court. In the Omnicare v. NCS HealthCare decision delivered in early April, the court announced a bright-line rule preventing targets in negotiated acquisitions from granting complete transactional certainty to a bidder prior to the shareholder vote. That’s bad news for m&a professionals who would like to insulate their transactions from the interference of subsequent bidders. It’s bad news for potential target companies that would like to lock up their choice of a merger partner. And it may also be bad news, on balance, for shareholders. But there is some good news for dealmakers in the NCS opinion. The bright-line rule that barely survived a highly divided bench is not likely to stand for long. The decision is a strong candidate for judicial or legislative reversal. Moreover, the process of reversal is likely to clarify and reaffirm the ability of dealmakers to seal their deals. This article takes a close look at the NCS case, the breadth and stability of the decision, and the likely grounds for narrowing or reversing it in the future. No Precommitment Strategies The bad news first. A broad reading of the majority opinion in NCS gives rise to this bright-line rule: Target boards no longer can agree to deliver certainty of closing to bidders in negotiated acquisitions. Instead, directors must retain an effective “fiduciary out” – the ability to scuttle the deal if a superior bid emerges before closing. This broad rule grew out of a narrow set of facts. NCS HealthCare Inc. was a fast-failing company in the health care industry. It desperately sought a deal to save itself from bankruptcy and employed two different investment banks to solicit a broad spectrum of potential bidders. These efforts succeed in turning up only two interested parties – Omnicare Inc. and Genesis Healthcare Ventures Inc. Omnicare and Genesis had a history together. Genesis had lost an earlier acquisition to a last-minute overbid by Omnicare. Still smarting from this encounter, Genesis insisted on not being treated as a stalking horse in its negotiations with NCS. Meanwhile, Omnicare seemed interested only in purchasing NCS assets in the context of bankruptcy, an alternative that offered no recovery to NCS shareholders. Genesis offered the superior proposal for NCS and was eventually awarded the deal. The NCS/Genesis merger agreement was well protected, containing no-talk provisions and termination fees. The most significant deal protection, however, was the combination of a submit-to-vote covenant with voting agreements from NCS’s Chairman, Jon Outcalt, and CEO, Kevin Shaw. The submit-to-vote covenant provided that the NCS board would submit the agreement to its shareholders regardless of any subsequent change in the board’s recommendation, and the voting agreements committed a majority of NCS’s voting power to approve the transaction. These provisions worked in tandem to guarantee approval of the NCS/Genesis transaction. If a premium bid came along, the NCS board could change its recommendation but it still would have to submit the Genesis transaction to a shareholder vote, the outcome of which, thanks to the voting agreements, was assured. The deal, in other words, was done with the signing of the merger agreement. Or so it seemed. When Omnicare lobbed in a superior proposal after the signing of the NCS/Genesis agreement, the NCS board could do nothing more than lamely explain to its shareholders that “the existing contractual obligations to Genesis currently prevent NCS from accepting the Omnicare…proposal; and…the existence of [certain] voting agreements…ensure NCS stockholder approval of the Genesis merger.” Omnicare, however, could do something more. It sued. Chancery Court Decision The Delaware Court of Chancery rejected Omnicare’s challenge to the NCS/Genesis transaction. In finding that NCS board behaved reasonably in agreeing to the deal protections, the court emphasized the broad market check employed by the NCS board. The opinion by Chancellor Stephen Lamb stated: “After looking for more than two years for a transaction that offered fair value to all NCS stakeholders, the board acted appropriately in approving the Genesis merger proposal, including the deal protection’ devices demanded by Genesis.” The Chancery Court rejected the Omnicare challenge, in other words, because NCS had been thoroughly shopped. Other bidders had had their chance, and now it was time to get on with it. A deal may, at some point, be done. Supreme Court Majority Opinion The Delaware Supreme Court disagreed. In a 3-2 split decision, it reversed the Chancery Court and held that the NCS board had breached its fiduciary duties in agreeing to the submit-to-vote covenant in the context of the voting agreements. The deal protection devices would, therefore, be unenforceable. The Supreme Court invoked two sources of doctrine for its holding: * “Enhanced scrutiny” under Unocal, and * The principle, supposedly derived from the QVC decision, that a board may not “disable” itself from carrying out its fiduciary duties. Unocal analysis looks to the reasonableness of a board’s response to a perceived threat to corporate policy. The Supreme Court’s application of Unocal to deal protection provisions is founded on an analogy between deal protections in friendly merger agreements and defensive actions in hostile takeover contests. According to the court, deal protections in friendly mergers call for enhanced scrutiny in the same way as charter provisions defending against hostile takeovers. Because it treated the voting agreements as “inextricably intertwined” with the submit-to-vote covenant, the Court viewed the NCS deal protection devices as “preclusive and coercive,” in violation of the Unocal standard. As an alternate basis for the holding, the majority argued that the voting agreements gave rise to a special duty on the part of the board to protect the interests of the “minority” shareholders – those shareholders not party to the voting agreements. Quoting the QVC decision for the proposition that the creation of “a cohesive group acting together” imposes special duties on the board to protect the minority shareholders, the Court held that the NCS board violated those duties in failing to reject the Genesis deal when Omnicare’s superior transaction came along. Satisfying this special duty to the minority would require, in other words, the retention of an effective termination right to the first transaction, which the NCS board had failed to provide when it agreed to the deal protection devices with no fiduciary out. These lines of analysis gave birth to the bright-line rule of the case. In order to be “reasonable” under Unocal and consistent with the board’s duties to the minority under QVC, a transaction cannot be completely protected, and an escape clause is required by law. In the words of the Court, “The NCS board was required to negotiate a fiduciary out clause to protect the NCS stockholders if the Genesis transaction became an inferior offer.” Perhaps more important than the Court’s doctrinal analysis is the majority’s plain hostility to completely protected merger agreements. The language of the majority opinion seeks to arrive at a principle, not a specific holding. Directors sign up deals. Shareholders accept or reject them. Directors cannot skip the second step, the Court seems to say, and complete the transaction themselves without giving shareholders a real opportunity to reject it. A deal, in other words, can never be done before the shareholder vote. Target boards must be free to consider, and take, other bids. If a better bid comes along, it is not enough for the target board to change its recommendation. It must be able to get out of the contract. As a result, targets no longer can follow a “precommitment strategy,” offering contractual certainty as a means of negotiating a better deal for shareholders. Working Around the Bright-Line Rule Practitioners will have a hard time designing work-arounds to the court majority’s mandatory out rule. Any action taken by the target board to seal a particular deal may be viewed as preclusive or coercive if it achieves the desired effect of foreclosing other bids. Adapting to the narrow NCS rule barring submit-to-vote covenants with majority voting agreements, bidders may seek voting agreements for significant minority blocks of voting power. A shareholder voting agreement in the high 30% to low 40% range may offer substantial protection but, because it can still be defeated in the shareholder vote, not be counted as preclusive or coercive. How high a bidder may safely go in locking up the shareholder vote, however, is unclear. There is some authority from Delaware courts suggesting that a voting agreement in the 40% range may count as preclusive, but there is also authority going the other way. In any case, the Supreme Court’s reasoning in NCS clearly leaves room for a court to find that 40% is too much. The bright line is based on the delivery of certainty, not an arbitrary percentage of voting power. If de facto certainty can be delivered with 35% of the vote, there is space for courts to invalidate those agreements. In lieu of locking up blockholders with voting agreements, bidders may seek to establish certainty by getting these large holders to commit to tender into a particular offer. This, however, may run afoul of target antitakeover defenses, specifically the poison pill, by causing the bidder to trigger the definition of “acquiring person.” Obviously, targets could avoid this problem by removing their pill. However, the removal of a pill requires board action, and in the context of an acquisition proposal, such board action may be all a court needs to deem the action “defensive,” and if “preclusive,” then invalid. One way around this problem would be for any company seeking an acquisition partner to remove its poison pill and opt out of state antitakeover laws in advance. The lack of a poison pill is not likely to substantially reduce the company’s takeover preparedness since a poison pill can be adopted at any time, even overnight, should a hostile bid arise. Because all Delaware companies are protected by this “shadow” pill, it is less necessary from the perspective of takeover defense to have an actual pill, as opposed to the mechanisms for quick adoption. The advance removal of a company’s poison pill may pave the way for a successful precommitment strategy since, in the absence of a pill, no board action would be necessary to enable blockholders to commit to a negotiated tender offer. Of course, not all prospective targets have significant blockholders, and it is in the absence of such an ownership structure that the Court’s rule against transactional certainty will have the most bite. Furthermore, if the Court really means to bar precommitment strategies, as the breadth of the majority’s language suggests, the design of provisions intended to deliver contractual certainty may be a futile endeavor. Harming Shareholder Welfare? A bright-line rule foreclosing precommitment strategies is bad both for targets and acquirers (as well as their advisers) that would like to conclude favored deals without worrying about the interference of subsequent bidders. It is also bad for shareholders generally. Although a narrow ex post perspective on shareholder welfare supports the view that the welfare of NCS shareholders was maximized by pursuing the subsequent Omnicare proposal at a $2-per-share premium over the Genesis offer, it is not clear that shareholder welfare on the whole would be served by a rule preventing target boards from providing contractual certainty to a would-be acquirer. The choice facing the NCS directors when they agreed to the Genesis transaction and the deal protections was not take this deal versus wait for a superior bid. It was take this deal or wait for a potentially worse one and, quite possibly, no deal at all. Recall the context of the NCS/Genesis negotiations. Omnicare had offered a low-ball bid for NCS assets in bankruptcy. NCS approached Genesis for a competing proposal. Genesis expressed interest but refused to be treated as a stalking horse and insisted on contractual protection. Under the post-NCS rule barring strong deal protections, NCS would have been forced to respond that it could only offer limited contractual protection due to the requirement that it include a fiduciary out. While it is impossible to know what would have happened under these circumstances, Genesis might well have walked away, leaving NCS with only Omnicare’s inferior bankruptcy bid. The NCS shareholders plainly would have been worse off. Seeking to avert this situation, NCS offered something of value to Genesis – certainty – and as a result was able to sign a deal at a higher price than was then otherwise available. As Chief Justice Veasey, writing in dissent, pointed out: “Certainty itself has value. The acquirer may pay a higher price for the target if the acquirer is assured consummation of the transaction. The target company also benefits from the certainty of completing a transaction with a bidder because losing an acquirer creates the perception that a target is damaged goods, thus reducing its value.” In this way, Genesis and NCS “exchanged certainty” as an element of their bargain and as a part of their deal, not as a response to a hostile threat. The ability to provide contractual certainty is an important element of value that targets can offer to would-be buyers. And it is an element of value that the majority’s opinion in NCS appears to take away from target boards. One should not be surprised if, as a result, target companies on the whole sell for less. That is the really bad news. Stability: Another Van Gorkom? Now for the good news. The majority’s bright-line rule is not likely to last. It is a strong candidate for judicial or legislative reversal. And the process of reversal is likely to clarify and reaffirm the ability of dealmakers to seal deals. The NCS court’s foray into micro-management of the deal process may remind lawyers of another famous, perhaps infamous, Delaware Supreme Court decision: Smith v. Van Gorkom. In Van Gorkom, as in NCS, the Court split 3-2 on a holding that a board of directors agreed to a deal too quickly and protected it too much. The Van Gorkom decision unleashed a flood of criticism that ultimately resulted in judicial and legislative reversals. By citing Van Gorkom in the first footnote of his dissent, Chief Justice Veasey has hinted that the Court may be in store for more of the same after NCS. Although a direct judicial reversal of NCS is unlikely due to the deference accorded to legal precedent, the famously fact-intensive nature of the Delaware corporate law leaves ample room for subsequent cases to narrow the scope of its holding. Such a narrowing can effectively amount to reversal, limiting the broad principle announced by the majority in NCS to the narrow facts giving rise to the case. Each of the dissenting Justices, Veasey and Steele, stated their inclination to read the majority opinion very narrowly, as applying only to the specific combination of a submit-to-vote covenant with majority shareholder voting agreements. It would take only one more vote to approve a different set of deal protections with the same de facto effect – certainty – thus invalidating the broader principle underlying NCS. As the NCS rule is narrowed, a new, more permissive standard is likely to emerge. If the dissenting opinions are any guide, the new standard would analyze transactional certainty not under the “preclusive or coercive” aspect of Unocal but rather on the basis of shareholder welfare and the good faith decisionmaking of the target board. In those situations, including the factual setting of NCS, where there is no evidence to support a claim of self-interested decisionmaking on the part of the target board, a board’s precommitment strategy may be approved as a valid attempt to promote shareholder welfare. Although such an outcome is plainly contrary to the majority’s reasoning and broader message in NCS, as long as the future transaction does not enact its precommitment strategy with a submit-to-vote covenant plus majority voting agreements, the Court can establish this rule without overruling NCS. While concerns regarding the stability of adjudicated outcomes reduce the likelihood of a judicial reversal of the specific holding of NCS, the same concerns do not constrain the legislature. Because the majority opinion in NCS puts a particular spin on the Delaware General Corporation Law (“DGCL”), the state legislature has been given an open invitation to clarify the statute. In so doing, the legislature may choose to void the specific holding of NCS. Moreover, it may well have the political momentum necessary to do so. The majority decision in NCS imposes a particular reading on the Delaware statute. Prior to the NCS opinion, Section 251(c) of the DGCL appeared to give the target board an unrestricted right to agree to submit transaction proposals to shareholder vote in spite of a change in heart and resulting negative recommendation. The section read, in relevant part: “The terms of the [merger] agreement may require that the agreement be submitted to the stockholders whether or not the board of directors determines at any time subsequent to declaring its advisability that the agreement is no longer advisable and recommends that the shareholders reject it.” The NCS decision has effectively added language to Section 251(c), allowing boards to submit proposals with negative recommendations only if approval of the agreement is not otherwise assured. An obvious objection to this interpretive gloss is that the extra language inserted by the Court is nowhere to be found in the statute. Had the Delaware legislature wanted it to add it, it could easily have done so. Because the extra words are not in fact there, we ought not to pretend they are. Anticipating this objection, the Court argued that the background of fiduciary duty imposed its reading on the statute: “Taking action that is otherwise legally possible…does not ipso facto comport with the fiduciary responsibilities of directors in all circumstances.” This puts the issue squarely back to the legislature. There is good reason to believe, given the invitation to accept or reject the Court’s reading of the statute, that the Delaware General Assembly will reject it. Rejection and reversal would be backed by Delaware corporations that view the NCS rule as harmful to shareholder welfare as well as their legal and financial advisers who view the NCS rule as bad Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com