FIDUCIARY DUTIES IN CONSIDERING DEAL LOCKUPS: WHAT S A BOARD TO DO? Diane Holt Frankle 2010 DLA Piper LLP (US)

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1 FIDUCIARY DUTIES IN CONSIDERING DEAL LOCKUPS: WHAT S A BOARD TO DO? Diane Holt Frankle 2010 DLA Piper LLP (US) In a public company acquisition, significant time is devoted to the negotiation of contract provisions which are designed to make it difficult for a new party to interfere with or break up the transaction embodied in the existing acquisition agreement. These provisions, generally referred to as deal lockups, raise thorny issues for the board of directors of the target public company. The premise for deal lockups is that the acquiror does not want to serve as a stalking horse for another bidder. Buyers must, however, deal with the reality that once a deal for a public company target is announced, a competing bidder can launch an offer to buy the target, going directly to the stockholders with a cash tender offer. Moreover, a bidder might simply publish its offer, seeking to induce a no vote on the current deal from target stockholders. In light of these possibilities, the buyer s goal is to have a deal which is as fully locked up as possible, so that another bidder cannot expect to unseat the buyer easily. In contrast, the goal of the board of the target is to keep some flexibility to consider a better deal. The target board may believe the deal on the table is the best possible deal at the time, but it can t be sure circumstances won t change and another buyer with a significantly better proposal might materialize. The target board must also take into account the fact that the deal on the table is a bird in hand and there may not be another alternative as good for the stockholders available to the target at least in the near term. And so the negotiating lines are drawn. This dance is complicated by the fact that the buyer must be careful not to negotiate too much of a good thing in terms of deal lockups. If the buyer is too assertive, the transaction can be so tightly locked up that the provisions are preclusive and therefore illegal in some circumstances. The buyer s best friend in a later court challenge to the deal is a strong target board and target s counsel who negotiate away offensive, overly protective lockup provisions. The record of the process of negotiation can be as important as the actual provisions agreed upon. Typical deterrents to competing proposals are no shop clauses, breakup fees, termination provisions, voting agreements, and option agreements. The target may also have existing protection in the form of a stock purchase rights plan (or poison pill ). This outline will consider the issues acquiror s and target s counsel and target s board should consider in negotiating deal lockups. The discussion below focuses on Delaware law, which is well developed in this area. Courts in other jurisdictions may give deference to Delaware court decisions, but of course for deals not governed by Delaware law, practitioners should also review applicable case law and statutes. As an introduction, this outline reviews the fiduciary duties applicable to directors considering a proposal for a business combination, the preparation essential to permit the board 1

2 of directors maximum flexibility in considering such proposals, the role of counsel and the process advisable for board consideration of a transaction. The outline then summarizes the key principles that a board may consider regarding deal lockups. I. Consideration of an Acquisition Proposal: The Process is Key. Process is important. It is the lawyers role to understand how the record should develop. Lawyers advise on the process necessary to create a record that enables directors to have the protection of the business judgment rule. Counsel controls the process. Counsel should develop the steps in the process necessary to assist the directors in meeting their duties, considering the following: A. Is the board acting carefully, or instead with undue haste or at the behest of the CEO without independent analysis? B. Is the board well-informed? C. Is the board in no way personally interested in the outcome? D. If the board is taking a defensive action, is the action a reasonable response to a threat reasonably perceived? E. In considering the process, keep in mind that the business judgment rule protects directors if they meet the duty of care, the duty of loyalty and the duty to act in good faith. 1. One court explained that the duty of care in the context of mergers is the duty to act in an informed and deliberate manner in determining whether to approve an agreement of merger before submitting the proposal to the stockholders. Smith v. Van Gorkam, 488 A.2d 858, 873 (Del. 1985). The short time frame in such situations poses severe challenges to assuring that the board is adequately informed. a. Here are some practical guidelines from the cases on how a board satisfies the duty of care; these guidelines should assist counsel in developing a schedule for the consideration of an unsolicited proposal: (1) Avoid not only haste, but the appearance of haste. Major decisions should be made only after directors have had a full opportunity to digest all available material information. More than one board meeting will likely be required. The parties must remain sensitive to the possibility of leaks. 2

3 (2) Review and consider carefully all available material information and carefully review all relevant documents prior to authorizing their execution. Counsel must be prepared to brief the board of directors on all material terms of the bidder s proposal, as well as any negotiations or discussions with the bidder, and any alternative proposals under negotiation. (3) Consider the advice of advisors or experts, including outside counsel and the corporation s investment banker. The board is permitted to rely reasonably on experts. (4) Consider the advice of Company officers and employees who would be expected to have relevant information on the subject. It will be important to have briefings from the senior management on the Company s strategic plan, how the proposed transaction fits with that plan and alternatives, including other possible transactions and remaining independent. (5) Ask questions and actively probe and test all information presented to the directors. The directors most at risk are those who passively rely on a strong CEO. Counsel s role is in part to assist the directors in developing the record. (6) The acquiring corporation s board also has a duty of care, of course. Ash v. McCall, 2000 WL (Del. Ch. 2000). (7) In In re Netsmart Technologies, Inc., Shareholders Litigation, 924 A.2d 171 (Del. Ch. 2007), the court noted the need to document all meetings carefully through minutes. 2. The duty of loyalty requires that a director make decisions based on the best interests of the corporation, and not on any personal interest. Directors are required to have an absence of personal financial interest in the matters before them. a. Directors who may become directors of the combined entity or who receive directors fees are generally not viewed as interested. 3

4 b. Officers who serve as directors are presumed to be interested because at the time of the acquisition such officers may lose their livelihood, or may continue their employment with the new owner. Note however that the Delaware Chancery Court has held that having the officers actively involved in the negotiations did not demonstrate an abdication of director duties when the directors were regularly briefed by management, and there was no showing that management had any concerns about job security or any showing that the primary motivation of management for the transaction was to increase the size of the company for the benefit of the manager. Wayne County Employees Retirement System v. Corti, 2009 WL (Del. Ch. 2009) ( Activision ). c. Employment or severance agreements providing compensation in the form of a severance or acceleration of vesting of options or restricted stock create a personal financial interest in such persons, to the extent the officer/director will receive a benefit different from the stockholders. d. Investment bankers or attorneys who serve on the board of directors may be deemed to be interested if their employer receives fees as a result of the transaction. e. Special interests must be fully disclosed to the entire board. f. In In re The Topps Company Shareholders Litigation, 926 A.2d 58 (Del. Ch. 2007), Vice Chancellor Strine explains, When directors bias the process against one bidder and toward another not in a reasoned effort to maximize advantage for the stockholders, but to tilt the process toward the bidder more likely to continue current management, they commit a breach of fiduciary duty. g. In McPadden v. Sidhu, 964 A. 2d 1262, Chancellor Chandler held that gross negligence is not grounds for a breach of the duty of loyalty or good faith, and held that claims against directors could be dismissed, but that an officer who is alleged to have breached the duty of care and the duty of loyalty does not benefit from a Section 102(b)(7) exculpation provision in the charter. h. Chancellor Chandler declined to dismiss a claim for breach of duty of loyalty claim arising from venture-backed company board s approval of a merger where the common received no payment, there was a management bonus plan paid out and the preferred received partial satisfaction of their liquidation preference; the target company was doing well-financed and profitable; Chancellor Chandler noted that the complaint supported a 4

5 reasonable inference that the interests of the common and preferred stock diverged as to whether to pursue merger and that allegations of ownership and other relationships of a majority of the directors to the preferred stockholders were sufficient to support an inference that a majority of the board was interested or lacked independence with respect to the decision to approve the merger, rebutting, at the motion to dismiss stage, the business judgment presumption. In re Trados Incorporated, 2009 WL (Del. Ch. 2009). 3. Courts have held that where a majority of the board of directors consists of independent directors, the board meets the requirement of independence, absent facts demonstrating control of the process by the interested directors. The court will carefully examine allegations of conflicts of interest or personal benefits. See In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003). 4. If a majority of the directors are interested, the board of directors can form a special committee comprised solely of independent directors. a. See Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110, 1117 (Del. 1994) and Kahn v. Tremont Corporation, 694 A.2d 422 (Del. 1997) for the Delaware Supreme Court s view on the independence of special committees. Arm s length bargaining is critical and the directors chosen for the committee must not have any relationship with affiliates that suggests undue influence. Krasner v. Moffet, 826 A.2d 277, (Del. 2003) ( the directors, not the plaintiff shareholders, have the burden of proving that a merger was approved by a committee of disinterested directors, acting independently, with real bargaining power to negotiate the terms of the merger ). b. The Delaware Supreme Court reaffirmed this view in McMullin v. Beran, 765 A.2d 910 (Del. 2000); see also In re Digex Inc. Shareholders Litigation, 789 A.2d 1176 (Del.Ch. 2000) (CA 18336) ( there is a strong role under Delaware law for meaningful independent director committees ), In re Cysive Inc. Shareholders Litigation, 836 A.2d 531 (Del. Ch. 2003) (special committee process met standard for entire fairness). c. Counsel should be aware of the effect on the process as a result of more negotiation, independent professional advisors (counsel and investment bankers) and more meetings. It is that power [to say no] and the recognition of the responsibility it implies that gives vitality to the device of special board committees in change of control transactions. In re First Boston, Inc. Shareholders Litigation, 1990 Del. Ch. LEXIS 74 (Del. Ch. June 7, 1990). See 5

6 In re Cox Communications Inc. Shareholders Litigation, 879 A. 2d 604 (Del. Ch. 2005) (Vice Chancellor Strine comments on attorneys fees applications brought by plaintiffs challenging merger involving controlling stockholders). d. Under Kahn v. Lynch, a merger with a controlling shareholder is always subject to the entire fairness standard of review, regardless of the use of a special committee or approval by minority stockholders, although the burden of persuasion shifts to the plaintiffs. In In re Cox Communications, Inc. Shareholders Litigation, 879 A. 2d 604 (Del. Ch. 2005), Vice Chancellor Strine commented on the standard of review in cases involving mergers with controlling shareholders, suggesting that if the controlling shareholder from inception subjected the merger to negotiation and approval by an independent committee and approval by the minority shareholders, the business judgment rule should presumptively apply. In this case, Vice Chancellor Strine suggested that the directors should obtain dismissal of the action unless the plaintiffs plead particular facts that the special committee was not independent or was not effective because of its own breach of fiduciary duty or wrongdoing by the controlling shareholder or the approval of the minority stockholders was tainted by misdisclosure or actual or structural coercion. e. The composition of the special committee is of central importance. The courts place more trust in a multi-member committee; two heads are indeed thought to be better than one. A single member committee, is required, like Caesar s wife, to be above reproach. Gesoff v. IIC Industries, CA 19473, 2006 WL (Del. Ch. May 18, 2006), quoting Lewis v. Fuqua, 502 A.2d 962, 967 (Del. Ch. 1985). f. The effectiveness of a special committee often lies in the quality of the advice its members receive from their legal and financial advisors. In re Telecommunications, CA No , 2005 Del.Ch. Lexis 206 (Del. Ch. 2005). A special committee s decision to use the legal and financial advisors already advising the parent alone raise[d] questions regarding the quality and independence of the counsel and advice received. Id., accord Gesoff v. IIC Industries, CA No , 2006 WL (Del. Ch. May 18, 2006). g. The special committee s actions are judged throughout the process. In re Toys R Us, Inc. Shareholder Litigation, 877 A.2d 975 (Del. Ch. 2005) (Vice Chancellor Strine held that directors employed a thorough and independent process to explore strategic alternatives, 6

7 and had broad discretion as to process and negotiation of deal protection devices.) h. In In re Netsmart Technologies Shareholders Litigation, 924 A.2d 171 (Del. Ch. 2007), the court commented that management s involvement in the process, either through unsupervised diligence meetings or regular attendance at special committee matters could taint the process; the special committee needs to control the process. Directors should oversee each part of the sales process to assure value maximization. i. In In re Loral Space and Communications Inc. Consolidated Litigation, 2008 WL (Del. Ch. 2008), Vice Chancellor Strine disregarded the special committee process in negotiating the terms of a financing by the controlling stockholder, noting that their desultory efforts did not fulfill their intended function, and reformed the preferred stock into non-voting common stock. j. In Louisiana Municipal Police Employees Retirement System v. Fertitta ( Landry s), 2009 WL (Del. Ch. 2009), Vice Chancellor Lamb found a reasonable inference that a committee had breached its duty of loyalty from the committee s failure to employ a poison pill to prevent the controlling stockholder from obtaining control without paying a control premium. The facts lead to an inference that the stockholder used his influence to his benefit and the committee willingly acquiesced in his scheme. 5. If the board is not independent, a transaction may be attacked as an interested director transaction, and the board will generally have the burden of proving the entire fairness of the transaction, or an equivalent concept under applicable state law. See In re Cysive Inc. Shareholders Litigation, 836 A.2d 531 (Del. Ch. 2003) (special committee process met standard for entire fairness). 6. Directors must act in good faith. Courts have held that a breach of the duty of good faith could be found in conduct by disinterested directors that constituted a conscious disregard of their duty to oversee the business of the corporation. See In re The Walt Disney Company Derivative Litigation, CA No , 825 A.2d 275 (Del. Ch. 2003) and 2005 WL (Del Ch. August 9, 2005); affirmed; CA No. 411,2005, 2006 WL (Del. June 8, 2006) (there is lack of good faith if director acts with intentional dereliction of duty or a conscious disregard for one s responsibilities, or exhibits deliberate indifference and inaction in the face of a duty to act). See also In Re Emerging Communications Inc. Shareholders Litigation, C.A. No , 2004 WL (Del. Ch. 2004). 7

8 7. In Lyondell Chemical Co. v. Ryan, 970 A. 2d 235 (Del. 2009), the Delaware Supreme Court held that an arguably imperfect attempt to carry out Revlon duties cannot be equated with a knowing disregard of duties. The Supreme Court held that there are no legally prescribed steps that directors must follow to satisfy their Revlon duties. There is a vast difference between an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties. Id. See also Wayne County Employees Retirement System v. Corti, 2009 WL (Del. Ch. 2009) ( Activision ), where the court held that the plaintiff did not sustain his burden of proof as to a breach of the duty to act in good faith, where the board formed a committee to oversee the process for the sale of the company, the committee met several times with its financial advisors, the committee reviewed analyses, no alternative bidder emerged in seven months, and the board received a fairness opinion. The court also held there was no requirement of a separate control premium. 8. The Chancery Court in Louisiana Municipal Police Employees Retirement System v. Fertitta ( Landry s), 2009 WL (Del Ch. 2009), found a reasonable inference that a special committee breached its duty of loyalty from the board s failure to employ a poison pill to prevent the controlling stockholder from obtaining control without paying a control premium. 9. If a parent corporation seeks to acquire or sell a majority owned subsidiary, the directors of the parent corporation have certain duties to the minority shareholders. a. A majority shareholder s tender offer must meet the following conditions: (i) such offer must be subject to the approval of a majority of the shareholders other than the majority holder or people affiliated with it; (ii) the controlling shareholder must promise to buy the remaining shares of the company at the initial offer price if it obtains more than 90% of the shares; and (iii) the controlling shareholder must make no threats of retribution if the target s board or shareholders reject the offer. In re Pure Resources, Inc. Shareholders Litigation, 2002 WL (Del. Ch. 2002). If a majority shareholder does not meet the conditions above, the tender offer could be considered coercive and the consummation of the offer may be enjoined by the Court. b. In the context of a merger of a subsidiary with a third party where the minority shareholders are powerless to prevent it: (1) the directors of the subsidiary have an affirmative duty to protect the minority shareholders interests; (2) the board cannot abdicate its duties and leave the shareholders alone to determine how to respond; and (3) the board has a duty to assist the minority shareholders by ascertaining the subsidiary s value as a going concern. McMullin v. Beran, 765 A.2d 910 (Del. 2000). See 8

9 Section I.E. 4(d) above regarding Vice Chancellor Strine s suggestions in In re Cox Communications, Inc. relating to the burden of proof in a case challenging a merger involving a controlling stockholder. c. In the context of a short-form merger, absent fraud or illegality, appraisal is the exclusive remedy available to a minority stockholder who objects to a short-form merger. Additionally, the parent is not required to establish entire fairness in a short-form merger, however, the duty of full disclosure remains. Where the only choice for the minority stockholders is whether to accept the merger consideration or seek appraisal, they must be given all the factual information that is material to that decision. Glassman v. Unocal Exploration Corp., 777 A.2d 242 (Del. Supr. 2001). d. In the context of a majority shareholder s tender offer, in which approval of the majority of the minority is required to consummate the tender offer, the parent is under no obligation, absent evidence that material information about the offer has been withheld or misrepresented or that the offer is coercive in some significant way, to offer a fair price, or any particular price, for the minorityheld stock. In re Siliconix Incorporated Shareholders Litigation, C.A. No , 2001 WL (Del. Ch. 2001). e. In the context of a subsidiary s waiver of Delaware General Corporation Law Section 203 (to permit the parent to sell itself to a third party), the subsidiary s board should have a meaningful independent director committee to negotiate with the acquirer from the beginning and approve such waiver. In re Digex, Inc. Shareholders Litigation, 789 A.2d 1176 (Del Ch. 2000). f. In a controlling stockholder freezeout, Vice Chancellor Laster observed that the business judgment rule, rather than entire fairness with a burden shift, is the appropriate standard of review only for a freeze-out where the first step tender offer is both negotiated by and recommended by an independent special committee and the tender offer is conditioned on the approval of a majority of the unaffiliated stockholders. In re CNX Gas Corporation Shareholders Litigation, CA No VCL., 2010 WL (Del. Ch. May 25, 2010). He observed that review otherwise should proceed under entire fairness, citing In re Cox Communications, Inc. Shareholders Litigation, 879 A. 2d 604 (Del. Ch. 2005), and held that in the CNX case the review was under the entire fairness standard because the special committee did not make a recommendation in favor of the transaction. g. Chancellor Chandler held that that business judgment review 9

10 would only apply if a transaction were (1) approved by a disinterested and independent special committee AND (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders. In re John Q Hammons Hotels Inc. Shareholders Litigation, CA No. 758-CC, 2009 WL (Del. Ch. 2009). Since the majority-of-minority condition was waivable and because it was based on those stockholders voting and not all minority stockholders, Chancellor Chandler held that entire fairness would apply - even though the condition was not waived and even though a majority of all minority stockholders did approve the transaction. Id. II. What Preparation Is Advisable? Of course, preplanning and attention to the enhancement of stockholder value is advisable. A company should give attention to the following: A. Have a Strategic Plan. 1. What are the Company s key assets? How can their value be leveraged or enhanced? 2. How is the Company planning to expand? What are the possible risks and benefits? What are the costs and the likely return on investment? 3. What are the Company s prospects in key markets? What is the strategy to move into new markets? 4. Where is the Company vulnerable to competition? What steps should be taken to bolster the Company s position? B. Have good advisors, including counsel, accountants and investment advisors. 1. After the receipt of an unsolicited proposal, advisors should consult together, and to the extent possible, agree on advice. 2. Advisors need to gather information quickly and efficiently. a. What are other alternatives to this deal? b. What do we know about particular group/company? 3. Advisors must analyze obstacles to deal consummation (antitrust, regulatory, state antitakeover measures, contractual effects). C. What antitakeover measures are in place or available? 1. Regular review of antitakeover measures is critical. 10

11 2. Role of rights plan (poison pill). a. A rights plan is designed to deter closing of tender offer. b. The rights plan is essential to permit a defense to an all cash, all shares tender offer at an inadequate price. (See Section X below.) c. A rights plan does not prevent a proxy contest or the launching of a tender offer. d. Rights plans are disfavored by institutional investors; as a result, many corporations are terminating plans or not adopting such plans, awaiting the need in the face of a third party attack. 3. What other structural defenses are available? a. Do stockholders have a right to call a special meeting? b. Can stockholders act by written consent? c. Do stockholders have the right to fill vacancies or change the board size? d. Is the board classified and removable only for cause? e. Is notice required for director nominations or stockholder proposals? f. Consider whether other provisions (fair price, supermajority votes, consideration of factors other than price) apply. g. Note that a rights plan only remains in place if the board remains intact; note also that provisions in certificate or articles of incorporation cannot be amended without stockholder approval. 4. Is management incentivized to remain during transition period? a. The board should consider whether change of control or severance agreements are appropriate. b. The board should consider the impact of terms in option plans or agreements that provide acceleration of vesting of options or restricted stock on a change of control. III. Assessing Alternatives - The Process and Analysis. A. Legal briefing for the board. 1. Get board involved early and often; briefings are important. 11

12 2. Brief the board on their fiduciary duties; as the situation changes, review the fiduciary duties again in light of evolving factual scenario. 3. Consider disclosure issues (Basic, periodic reporting issues, Schedule 14D-9, if applicable, strategic considerations). 4. Consider trading ban (is there material inside information?); err on the side of caution. 5. A centralized and experienced spokesperson should be appointed to control communication; emphasize confidentiality of board deliberations; discuss dealing with media, stockholders, analysts. 6. Review D&O insurance, indemnification, limitations on liability. 7. Discuss the likelihood of litigation; advise regarding depositions, notetaking, electronic mail communication, etc. IV. What are Revlon duties and when do they apply; when is there a sale of control. A. Where the directors have determined that a sale of control or breakup of the company is inevitable, their duty is the maximization of the company s value at a sale for the stockholders benefit. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986). 1. In the sale of control context, the directors must focus on one primary objective -- to secure the transaction offering the best value reasonably available for the stockholders. Paramount Communications v. QVC Network, Inc. ( QVC ), 637 A.2d 34, 44 (Del. 1994). 2. A merger or other business combination in which stockholders are cashed out, or in which a stockholder or affiliated group of stockholders of the corporation control the continuing entity, is generally viewed as a sale of control, because the transaction at hand represents the only opportunity for stockholders to receive a control premium. B. Delaware courts have held that a stock for stock merger, where a majority of the shares in the continuing entity will continue to be held after the merger by a fluid aggregation of unaffiliated shareholders representing a voting majority, is generally not a sale of control. 1. This type of transaction is not considered a change of control because the target stockholders continue to have the opportunity to receive a control premium, even if the target stockholders will represent only a minority of the ongoing entity. Paramount Communications, Inc. v. Time, Inc. ( Paramount ), 571 A.2d 1140, 1151 (Del. 1989). 12

13 2. This is true even when the target stockholders will represent only a very small percentage of the voting stock of the acquiror. Arnold v. Society for Savings Bancorp, 650 A.2d 1270, 1290 (Del. 1994). 3. The law is yet unsettled as to whether the Revlon duties will apply if one stockholder, or a control group of stockholders, hold less than a majority of the voting stock (note, in QVC, Sumner Redstone held more than a majority). 4. Another open question is whether Revlon duties apply if the transaction involves a mix of cash and stock for example, 60% stock, 40% cash, or 60% cash, 40% stock. In a Chancery Court decision, In re Lukens Inc. Shareholders Litigation, 757 A.2d 720 (Del. Ch. Dec. 1, 1999), Vice Chancellor Lamb explained as follows: The Supreme Court has not set out a black line rule explaining what percentage of the consideration can be cash without triggering Revlon. I take for granted, however, that a cash offer for 95% of a company s shares, for example, even if the other 5% will be exchanged for the shares of a widely held corporation, will constitute a change of corporate control. Until instructed otherwise, I believe that purchasing more than 60% achieves the same result. C. Delaware courts have held that in determining the adequacy of the offer in a sale of control, directors may approve a transaction without employing an auction or a market check, so long as they are able to demonstrate that they possessed a body of reliable evidence on which to base their decision. QVC Network, Inc. v. Paramount Communications, Inc., 635 A.2d 1245, 1268 (Del. Ch. 1993), citing Barkan v. Amsted Industries, 567 A.2d 1279, 1287 (Del. 1989). See In Re Pennaco, Inc. Shareholders Litigation, 787 A.2d 691 (Del.Ch. 2001), in which Vice Chancellor Strine found that Revlon duties were met even though there was no auction, noting that although the target negotiated with a single bidder, it bargained hard and made sure the transaction was subject to a post-market agreement check unobstructed by onerous deal protection measures that would impede a topping bid. Accord. In Re The MONY Group Inc. Shareholder Litigation, 852 A.2d 9 (Del. Ch. 2004) (board decided to forego auction process in favor of agreements with single bidder followed by market check; court holds board acted reasonably in weighing pros and cons of various sales methods and choosing to forego auction). 1. The adequacy of the process to explore alternatives is the key issue. In reviewing a special committee s process in In re Toys R Us, Inc. Shareholder Litigation, 877 A.2d 975 (Del. Ch. 2005) Vice Chancellor Strine held that directors employed a thorough and independent process to explore strategic alternatives, and had broad discretion as to process and negotiation of deal protection devices. 2. In Barkan v. Amsted Industries, 567 A.2d 1279, 1287 (Del. 1989), the court focused on the board s body of reliable evidence, noting proactive 13

14 efforts by the board to inform itself. Thus, in response to the acquisition of a significant number of shares by a sophisticated investor, the board retained an investment banker to provide advice. The board formed a special committee to consider any change of control transactions that might develop. Over a period of ten months while the board thought a transaction might be coming the board considered numerous valuations of the company, both optimistic and pessimistic, to determine the propriety of a management led buyout and to orient itself as to the value of the company in the market. The company in Barkan was confronted with declining financial performance suggesting a sale might be the best value attainable and there were unique tax advantages in the management led buyout that supported an inference that no other bidder could top management s offer. The court also took into account the implicit 10 month market check preceding management s proposal and a lack of other bids during the intervening period in concluding the board had sufficient evidence to satisfy its Revlon duties in negotiating with the bidder. 3. In In re The Topps Company Shareholders Litigation, 926 A.2d 58 (Del. Ch. 2007), Vice Chancellor Strine considered the negotiation of price with a financial buyer and noted that the board had not used a presigning market check, and it is critical to his determination that there is a no unreasonable flaw in the board s price negotiations, given the lack of a presigning market check, that the board required a go-shop provision. 4. Vice Chancellor Strine provided further guidance on process in In re Netsmart Technologies, Inc. Shareholders Litigation, 924 A.2d 171 (Del. Ch. 2007), concluding that a post signing market check was insufficient effort to maximize shareholder value for a small cap technology stock, particularly where the company had attempted to shop itself a year earlier with no interested bidders, and the deal under agreement was with a private equity firm intending to retain management. The board must use reasonable efforts and a logically sound process. Vice Chancellor Strine noted the potential utility of a sophisticated and targeted sales effort tailored to a few logical buyers and the use of a banker with industry connections to market the company, and that the board can legitimately consider potential harm to the Company from a broad-based sales process. In particular, the failure to develop a sales process that investigated the potential for interested strategic buyers was suspect given that management continued in their employment with the private equity transactions. 5. Another 2007 case deals with the board s Revlon duties in a single bidder scenario. In re Lear Corporation Shareholders Litigation, 926 A. 2d 94 (Del. Ch. 2007) ( Lear ). Carl Icahn took a position in Lear, and in response the market price of the stock increased in anticipation of a possible transaction. Icahn offered a going private transaction and the board formed a special committee to consider the offer. He advised that if 14

15 the board wanted to do a pre-signing auction they could do so, but he would withdraw his offer. The committee was concerned that if he dropped out of discussions, the stock price would drop and also that in the event an auction did not produce another successful bid, Icahn could then offer less for the company. The company had previously made it clear that it was open to an invitation to be acquired, and no bidder materialized. The board was also concerned about the impact of an auction on the company s business and customer relationships. Icahn offered a go shop period, with a 3% termination fee. The special committee negotiated several concessions from Mr. Icahn, including a voting agreement to support a superior proposal, a lower break up fee during the go shop period and a longer go shop period. The court noted that the board had used the CEO as the primary negotiator, and although the court expressed some concerns about this decision, the court concluded that the committee had used its position to negotiate a better deal for the shareholders. The court upheld the process in Lear, noting that the board could take into account the fact that only Icahn had emerged as a bidder and the board risked losing that deal if it engaged in an auction process. 6. In Lyondell Chemical Co. v. Ryan, 970 A. 2d 235 (Del. 2009), the board of the target was confronted with a blowout premium bid. The board accepted the bid from a buyer without a market check or a post-signing go-shop of the transaction, relying on the post-signing market check and the significant premium of the bid. The Chancery Court had held that the board s failure to engage in a sales process could result in a breach of the duty to act in good faith, as a conscious disregard of duties. The Delaware Supreme Court reversed, holding that Revlon duties do not apply until the board decides to sell the company or the sale is inevitable, and that an arguably imperfect attempt to carry out Revlon duties cannot be equated with a knowing disregard of duties. Id. The Supreme Court held that there are no legally prescribed steps that directors must follow to satisfy their Revlon duties. There is a vast difference between an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties. Id. 7. In In re Dollar Thrifty Shareholder Litigation, CA No VCS, 2010 WL (Del. Ch. Sept. 8, 2010), the Dollar Thrifty board approved a merger agreement with Hertz without a presigning market check, ignoring a tepid approach from Avis late in the Dollar Thrifty s negotiation process with Hertz. Vice Chancellor Strine determined that the board did not violate its Revlon duties, although there was no presigning market check, as the record showed it used its reasonable judgment to determine whether it was a good time to sell, at what price, and had reasonably considered whether it had extracted all the value it could and whether it was ensuring the viability of a post signing market check. Vice Chancellor Strine advised that the board was entitled to consider the price compared to its view of the fundamental value of the corporation. 15

16 D. Note that even when there is no sale of control, and the actions of the directors are protected by the business judgment rule, the directors of course still have the duty of care to evaluate all information concerning the value of the transaction and any alternatives reasonably known to the board in determining whether to approve and recommend the transaction. V. What should the board of the target consider in approving deterrents to competing deals? When can a deal be locked up? Under Unocal Corporation v. Mesa Petroleum, 493 A.2d 946, (Del. 1985) where impediments to a competing transaction are included in the terms of a proposed business combination, a Delaware board of directors may have the additional duty to consider whether these terms are reasonably necessary to protect a legitimate corporate interest and are reasonably tailored to achieve the corporate purpose. A. The stricter scrutiny of the Unocal doctrine may apply to the board s decision to include lockup provisions in the merger agreement. Paramount, 571 A.2d 1140, 1152 (Del. 1989); see McMillan v. Intercargo Corp., 768 A.2d 492, n.62 (Del.Ch. 2000) (... deal protection terms self-evidently designed to deter and make more expensive alternative transactions would be considered defensive and reviewed under the Unocal Corp. v. Mesa Petroleum Co., Del. Supra, 493 A.2d 946 (1985) standard. ) B. One example of a legitimate corporate interest is a synergistic business combination in which the Company s stockholders will be able to participate in the long-term through a continuous equity interest and which the board believes will offer more value to stockholders in the long term than other available alternatives (including a cash tender offer). The board may reasonably conclude that the enhanced value offered by the combined entity due to synergies arising from the business combination offer greater value to the stockholders than any likely alternative transaction. C. Because lockup provisions may deter or preclude alternative bids which may offer a better immediate price to the stockholders, the board must analyze these provisions to determine that they are not so broadly drawn that they would deter competing bids offering substantially greater value to the stockholders, and should be satisfied that lockup provisions are a condition of the acquiror s deal. See e.g., McMillan v. Intercargo Corp., 768 A.2d 492 (Del.Ch. 2000). VI. No Shop Provisions. A. When are no shop clauses enforceable? 1. Under Delaware law, the board is permitted to contract away its ability to consider other deals in some circumstances. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). In Delaware, a no shop clause may be found to be enforceable if it is bargained for. The target should certainly negotiate 16

17 regarding the proffered no shop clause to test the theory that the acquiror won t do the deal without it. At a minimum, the target must also conclude that the protected deal offers enhanced value to stockholders. Most commentators agree that a no shop provision must have a fiduciary out (see below). In Phelps Dodge Corporation v. Cyprus Amex Minerals Co., CA No , 1999 Del. Ch. Lexis 202 (Sept. 27, 1999) Chancellor Chandler held that a straight no talk provision, with no fiduciary out, preventing the target from considering information about alternative deals, was likely unenforceable even in a non-revlon setting. Chancellor Chandler held the decision not to negotiate must be an informed one, and that an agreement foreclosing all opportunity to discuss alternatives is the legal equivalent of willful blindness. See also Ace Limited v. Capital Re Corporation, 747 A.2d 95 (Del. Ch. 1999) ( No talk provisions are troubling precisely because they prevent a board from meeting its duty to make an informed judgment with respect to even considering whether to negotiate with a third party. ) Compare In re IXC Communications, Inc. Shareholder Litigation, CA No , 1999 Del. Ch. Lexis 210 (October 27, 1999) ( Provisions such as no talk provisions are common in merger agreements and do not imply some automatic breach of fiduciary duty ). 2. Directors of private company targets are subject to the same standards. In Cirrus Holding Co. Ltd. v. Cirrus Industries, Inc., 794 A.2d 1191 (Del.Ch. 2001), Vice Chancellor Lamb noted in dicta that the target appeared to be for sale, the agreement in question would result in a change of control and therefore Revlon duties were triggered and he explained, As part of this duty, directors cannot be precluded by the terms of an overly restrictive no-shop provision from all consideration of possible better transactions. Similarly, directors cannot willfully blind themselves to opportunities that are presented to them, thus limiting the reach of no-talk provisions. That case involved the detailed analysis of a window shop provision. 3. The Ninth Circuit held in Jewel Cos. v. Payless Drugs Stores Northwest, Inc., 741 F.2d 1555, 1564 (9th Cir. 1984) that under California law, a corporate board of directors may lawfully bind itself in a merger agreement to forbear from negotiating or accepting competing offers until the shareholders have had an opportunity to consider the initial proposal. 4. The Delaware Chancery Court has held that a party to an initial merger agreement that is topped may maintain a damages claim against the target for breach of contract even if the buyer voluntarily declines to match the price offered by the topping bidder and is paid the termination fee and expense reimbursement required by the merger agreement, if it can prove that the target breached the no shop provisions prior to paying the 17

18 termination fee. Nacco Industries v. Applica, Inc., CA No VCL, 997 A. 2d 1 (Del. Ch. 2009). B. What kinds of actions are prohibited or mandated by a typical no shop? 1. Target must not initiate or solicit competing bids and must cease all ongoing discussions. a. The well-drafted provision will apply to the target, its officers, directors, employees, representatives, agents and affiliates. b. Beware of a formulation that prohibits the target board from entertaining or considering a proposal. If the board cannot consider a proposal, it cannot fulfill its duty to manage the corporation or to exercise the duty of care. See Phelps Dodge Corporation v. Cyprus Amex Minerals Co., CA No , 1999 Del. Ch. Lexis 202 (Sept. 27, 1999); Ace Limited v. Capital Re Corporation, 747 A.2d 95 (Del. Ch. 1999). This provision would also prevent target from satisfying its obligations to take a position within 10 business days after the announcement of the competing offer under Rule 14D-9. Typically, actions required under Rule 14e-2 and Rule 14d-9 are exempted from the no shop. 2. Target may not convey confidential information or assistance to a person in connection with an alternative proposal. a. A typical exception is the providing of information in response to a request for information in connection with an unsolicited bona fide written acquisition proposal. b. The right to provide information may be limited in a buyer s first draft to those transactions which are Superior Proposals (see discussion below); note that it is difficult for a competing bidder to make a proposal without due diligence, making this right illusory unless the right to provide information is conditioned on an offer that is reasonably likely to lead to a superior proposal. c. This right may be conditioned on the competing bidder being subject to a confidentiality agreement with standard terms, or substantially similar terms or on terms no more favorable to bidder than the agreement to which the acquiror is subject; target counsel should consider the effect of such a covenant and the possible negotiation of a right to waive other standstill provisions in some circumstances. (See discussion of Topps decision below.) 3. Target may not respond to competing bids, hold discussions with competing bidder, or enter into agreement with competing bidder. 18

19 a. Typical exception is except if the board of directors determines in good faith that such action is required to comply with the applicable fiduciary duties of the board of directors. This phrase is potentially ambiguous. In some circumstances the board may be legally permitted to contract away its right to consider other deals and in such cases the board s fiduciary duty would not provide a guaranteed freedom to consider and negotiate even with regard to a superior bid; see John F. Johnson, Recent Amendments to the Merger Sections of the DGCL will Eliminate Some - But Not All - Fiduciary Out Negotiation and Drafting Issues. Mergers and Acquisitions Law Report (Vol. 1, No. 20 at 777 (BNA 1998)); see also Ace Limited v. Capital Re Corporation, 747 A.2d 95 (Del. Ch. 1999). Other standard formulations give more flexibility to the target board: eg., where the failure to take such actions is inconsistent with the board s fiduciary duties or except as substantially required by the board s fiduciary duties. b. Often the right to terminate the existing merger agreement or enter into a new agreement is conditioned on the third party bid being deemed a Superior Proposal. What is a Superior Proposal? Must it be in writing? Must it be fully financed? Note that a deal requiring third party financing will not have committed financing without completion of due diligence. Counsel for target should carefully consider any provision which requires committed financing at the stage of providing information to a third party; often the definition of Superior Proposal addresses the need for available financing (and the bidder s ability to obtain financing). The definition may require that a Superior Offer not be subject to a financing contingency. In considering whether a bid constitutes a Superior Offer, it is typical to provide that the Board consider the terms and the likelihood of consummation. c. A requirement of a Superior Offer that the Board act based on a banker s opinion is suspect. See In Re IXC Communications, Inc. Shareholder Litigation, CA No , 1999 Del. Ch. Lexis 210 (October 27, 1999) ( No board is obliged to heed the counsel of any of its advisors and with good reason. Finding otherwise would establish a procedure by which this Court simply substitutes advice from Morgan Stanley or Merrill Lynch for the business 19

20 judgment of the board charged with ultimate responsibility for deciding the best interests of shareholders. ) The Board or committee is typically required to consider advice from a financial advisor. What advice is required? Must there be an opinion in writing? A Superior Offer must be more favorable than the current party s proposal. Is the standard more favorable from a financial point of view? What does superior mean in context of strategic transaction for stock? How does a Board or committee compare a cash deal to a stock deal? Consider also the right of buyer to match a competing proposal, and the possible chilling effect this match right has on a competing bidder. See In re Lear Corporation Shareholder Litigation, 926 A.2d 94 (Del. Ch. 2007) (Strine comments Match rights are hardly novel and have been upheld by this court when coupled with termination fees despite the additional obstacles they are [sic] present. ), citing In re Toys R Us, Inc., 877 A.2d 975, 980 (Del. Ch. 2005). d. Typically the right to consider a third party bid is conditioned on advice to the Board of Directors of target from legal counsel. Notice it makes a difference whether the board can act in good faith after consultation with outside legal counsel, or based upon advice of outside legal counsel, or based upon the written opinion of outside legal counsel. Target counsel should be wary of a requirement that the board must receive written opinion that the board is required to consider another deal in order to comply with its fiduciary duties, especially if a strategic transaction is being negotiated. Equally fraught with uncertainty is a requirement that the board s decision be based on counsel s advice or opinion. In Ace Limited v. Capital Re Corporation, 747 A.2d 95 (Del. Ch. 1999), Vice Chancellor Strine noted that, if the Merger Agreement in fact required the [target] board to eschew even discussing another offer unless it received an opinion of counsel stating that such discussions were required, and if [buyer] demanded such a provision, it is likely that [the provision] is invalid. The Vice Chancellor indicated that such a provision may be viewed as an abdication of the board s duty to determine its own fiduciary obligations. 20