Check under the “Resources” tab for the following downloadable PDF documents, updated for 2014:
M&A Issues Checklist
Short Primer on Public Company Issues
Public Company Reporting Checklist
Check under the “Resources” tab for the following downloadable PDF documents, updated for 2014:
M&A Issues Checklist
Short Primer on Public Company Issues
Public Company Reporting Checklist
In mediocre payout situations, transaction proceeds are unlikely to give a substantial (if any) return to common stockholders, yet may be sufficient to at least return the initial investment, and perhaps a liquidation premium, to preferred stockholders. In such a scenario, the practical implementation of fiduciary duties for privately held boards has historically been somewhat murky.
Prior to 2013, many issues generally surrounded liquidation payouts to preferred investors when allocated among various series of preferred investments, whether structured as bridge notes that attached large additional preferences, or as a pay-to-play, which immediately diluted non-participating legacy stockholders at the time of a bridge financing.
The 2013 In Re: Trados, Incorporated Shareholders Litigation case in Delaware renewed attention on this area by applying the rigorous “entire fairness” legal review standard to a board’s actions when it was unclear that a board was zealously evaluating the impact of decisions on all stockholders, as opposed to just preferred stockholders. The entire fairness standard, first set forth in the decision in Weinberger v. UOP, Inc. in 1983, requires the board (and not the plaintiffs) to prove that both a fair process and fair price were obtained for the stockholders. Although the Trados board happened to prevail on its particular facts, this rigorous standard highlights Delaware’s ongoing concerns in this context.
Despite the often-mandated acquisition of directors and officers liability insurance “tail policies,” public company acquirers are advised to more closely scrutinize the circumstances of a liquidation where the proceeds are unlikely to materially benefit all stockholders either by class (common/preferred) or series within a class (such as Series A or Series B). Retrospective reallocation of pieces of the pie among stockholders may cause unwanted negative publicity, management distraction and turbulence with continuing employees who are vital to making an acquisition work within the buyer’s organization.
The quandary of a “so-so” exit
Not all startups exit with values akin to Facebook’s acquisitions of WhatsApp, Oculus VR or Instagram. For startups that do not hit it out of the park − which is the majority of them − the fact pattern resembles in the following:
Prior to 2013, the answer was relatively simple. A target’s board of directors is usually ‘packed’ with members from investing venture capital funds and current members of management but rarely includes former CEO founder types or other former employees who vested on common stock prior to their departure). This mashup of VC investors and current management, with an occasional outsider thrown in, seeks the best price. In a lukewarm valuation scenario, that price may not be enough to pay off the liquidation preference overhanging the target – leaving little or perhaps nothing for holders of common stock. Yet employees hold common stock, meaning there is little incentive for those employees to hang around.
Alternative #1: The target’s board adopts a carveout or management incentive plan, reallocating some proceeds from a stockholder payout to employees to encourage them to remain. However, that results in lower proceeds for common stock holders, or even earlier preferred stock investors who must wait in line for the last-in investors to be paid their liquidation preference.
Alternative #2: The buyer embraces identified target employees and a promises a post-closing retention plan – but it then turns around and reduces the proposed purchase price to account for the post-closing retention value.
Historical focus on preferred stock payouts: The complicated issues in this situation historically revolved around circumstances where either the deal value was insufficient to pay the liquidation preferences for various early-stage venture investors even though a later stage preferred round may be paid in full – and even more thorny situations such as the infamous pay-to-play, where equity holders who do not participate in the bridge lifeline extension of cash either do not receive the 2X-5X preference in paying off such notes (thereby cramming them down further on the chain in a liquidation payoff when/if it occurs), or, in a true pay-to-play, the non-participating investors are massively diluted (crammed down) at the time of the new fundraising.
Management carveouts were routine: However, until 2013, “management carveouts” were an ordinary course feature of deals where venture capital investors wanted to retain employees in order to preserve some sort of saleable enterprise. The major downside of a carveout plan is that the proceeds to an employee would be tax characterized as ordinary income rather than capital gains on holding stock, since the extra money was not linked to their stockholdings but rather than their continued employment services to the company.
Trados reaffirms board duties to all stockholders: The 2013 In Re: Trados, Incorporated Shareholders Litigation emphasized that a board owes fiduciary duties to all stockholders – and using a management carveout to strip money from stockholders lower in the liquidation food chain than the venture capital funds affiliated with board members in order to give that money to people who would otherwise have no right to such money upon a liquidation invites great scrutiny from Delaware courts. While there are cogent business reasons to institute a management carveout, and Delaware is open to reasonable arguments, as shown in the eventual substantive outcome of Trados, there also is the outward danger of self-interest in venture capital funds and current management manipulating a carveout to deny the financial benefit of a liquidation to ousted founders, former employees or disillusioned prior investors. It is that very potential for abuse, even if most in Silicon Valley would posit it is far from the norm, that creates judicial review.
After-effects of Trados: Some commentators have suggested writing into a company’s certificate of incorporation that individual board members owe a duty more to their nominating entities (i.e. venture capital firms) than to all stockholders. There has been informal Delaware guidance that this would at least put other stockholders on notice. Left unsaid, however, is that savvy founders will likely become nervous and perhaps lurch even further towards dual class control plans (à la Facebook, Broadcom and others) to retain governance control.
The awkward position of a buyer: Leaving aside prospective machinations in startups, the implications of Trados leave an incoming buyer in an awkward position. By definition, a target will be loath to share details of the sale process with a buyer, lest it reveal how much leverage a buyer has in the process. However, in a management carveout situation – in which the sale may become subject to having to prove a “fair process/fair price” – a buyer needs to ask process questions of a target to at least get to the “fair process” prong. Although it is highly unlikely that Delaware would seek to unwind a deal post-closing, it is entirely foreseeable that a post-closing judicial quarrel between classes of stockholders would likely disaffect target employees who continue with the buyer. Those are the very people whom the buyer would like to completely focus on executing in the present, rather than struggling with post-facto examinations of value. Although the buyer’s liability is somewhat limited, in that Delaware courts scowl upon any indemnification of directors who are found to have breached their duty of loyalty, the uncertainty and publicity of ongoing litigation should be sufficient downsides to persuade a buyer to spend time on this subject with a target.
Nine practical remedies for acquirers
Among the practical remedies for acquirers in the prototypical “mediocre” deal, where payouts to common stockholders appear meager and/or a management carveout plan exists, are these:
In an unusual oral bench opinion, supplemented the following day with a Saturday letter to affected counsel, Vice Chancellor Sam Glasscock III of the Delaware Chancery court has found that Apollo Tyre Limited, a US$39 billion behemoth in India, continued to be under contract to acquire Cooper Tire & Rubber Company (NYSE: CTB), the second largest US tire manufacturer, for US$35 per share or US$2.5 billion, despite Cooper’s claims that Apollo was in breach of the agreement.
Cooper sought an immediate appeal, which as of the date of this alert remains pending in Delaware.
On its surface, the case seems a test of the limits of a requirement that Apollo use “reasonable best efforts,” which is a relatively opaque standard – an intermediate stop between “commercially reasonable efforts” and “best efforts” – the standard by which Apollo is bound to negotiate labor contracts with the United Steel Workers (USW). On November 8, Vice Chancellor Glasscock found that Apollo was using “reasonable best efforts” – even if the negotiations were not being conducted in the manner preferred by Cooper and even further if Apollo’s proposals to the USW were explicitly predicated on a deal price reduction by Cooper. He further found that the parties have “ample” time before a merger agreement drop-dead date of December 31 for Apollo to reach an accord with the USW, as a binding arbitrator found is required under Cooper’s labor agreements with the USW before the acquisition may close.
However, the deeper story lies in the tale of Cooper, and it is heavy reliance for approximately 25 percent of its revenue on a joint venture in the People’s Republic of China with the Chengshan Group. While the Apollo bid was under consideration, Chengshan was exploring its own bid to acquire its US joint venture partner. After the Apollo deal was announced, according to court testimony, Chengshan’s chairman complained of not receiving anything from the acquisition and further accused Cooper of divorcing its “son” and replacing it with Apollo as a “stepfather.” Apollo offered US$150-200 million to buy out Chengshan after the closing; Chengsan in return demanded US$400 million. Given that one would think the value could likely be bridged one way or another, it would seem reasonable to think that a non-compete in Cooper’s favor was lacking in these terms. Chengsan then promptly threw out Cooper managers from the Chinese plants after posting guards at the doors; its workers halted production of any Cooper branded tires; and the joint venture has since refused to supply to any financial information to its US parent.
This last piece of the puzzle is critical. The joint venture quagmire is apparently foremost in the minds of Apollo’s banks, at least according to e-mails produced in court. To no one’s surprise, those banks appear eager find a way to avoid moving forward with the proposed debt facilities.
Although Apollo’s bid is not subject to a financing condition (or “out”), the merger agreement does require Cooper to provide quarterly financial statements, in this case by Thursday, November 14. Cooper, by its own assessment, will almost certainly be unable to do so by this deadline, given its Chinese stalemate. Assuming Cooper breaches the information requirements, the acquisition financing evaporates and Cooper can find no other legal grounds on which to object, then Apollo would be relieved of having to rely solely on claiming a “material adverse effect” (MAE) to either terminate the acquisition or insist on a price renegotiation. Such a dance on MAE is not clear cut for Apollo, since Cooper claims Apollo was put on clear notice prior to entering into the acquisition contract that the Chinese joint venture could become problematic.
In sum, the Apollo/Cooper case has not become a seminal case on the limits of “reasonable best efforts.” Vice Chancellor Glasscock was acutely aware that Cooper could be accused of trying to avoid the specter of breaching the November 14 financial statement requirements by asserting the violation of Apollo’s “reasonable best efforts” requirements. Rather, this case instead has shone a bright spotlight on the perils and pitfalls of joint ventures. Although 25 percent is a healthy portion of an enterprise’s revenue, it remains a minority – a minority which in this case has thrown an otherwise viable company into legal chaos. Cooper’s board had not gone looking for a deal with Apollo – there was no auction process or even entreaties to put the company in play. However, if the Apollo deal at its current US$35 per share now disappears, it will be clear to all sorts of acquirers that Cooper is in play, and Cooper will in all likelihood be left in a less than optimal defensive state.
Delaware appears almost certain to adopt changes that would become effective August 1 to the Delaware General Corporation Law (DGCL) which would change the process for back-end mergers after a tender offer closes.
Under this change, a Buyer of over 50 percent (instead of the current threshold of over 90 percent) of shares of the Target will be able to effect a short-form merger without the burdensome and lengthy process of a further proxy solicitation and stockholder vote, which, by definition, the Buyer always wins.
Such DGCL amendments represent the most significant shift in the balance between usage of a proxy statement vs. a tender offer in a cash-based business combination since the clarification of the best price rule by the SEC in 2006 once again opened tender offers as a favored cash acquisition route.
Acquisitions of publicly traded companies in the United States are effected through one of two mechanisms: a tender offer or a proxy statement solicitation process. For background on each of these two alternatives, visit this page.
There is almost unanimous professional agreement that a tender offer, absent the issues below, is preferable to a proxy statement route for cash deals. It’s simple: a tender is quicker. While a proxy statement requires review by the Staff of the Securities and Exchange Commission before it is launched; a tender offer is reviewed post-launch. And, even then, only in limited cases has the Staff at the SEC historically required re-circulation of tender offer documents in response to Staff comments.
Clearing Staff comments concurrent with, rather than prior to, launch of a solicitation may seem a rather minor gain. It is not. That span of time is fraught with deal uncertainty. No matter how brief the period, every minute in which a public deal is floating in the ether is another minute in which it is subject to a possible topping bid from a third party.
So why not always just do the tender offer when cash is the deal currency? In a tender offer, a Buyer can set a minimum condition at or above 50 percent of Target shares for closing the tender. If more than 90 percent of Target shares are delivered, then Delaware currently allows for a painless short form merger which merely requires the Buyer’s signature and the promise to give the squeezed out minority holders identical consideration as that received in the tender. If less than 50 percent of Target shares are delivered, then no tender closing occurs and the deal is either dead or in need of re-examination by both sides. It is, however, the nebulous range between 50 percent and 89.9 percent that presents tricky issues.
Absent fancy inventions, a Buyer who closes a tender offer at between 50 and 90 percent of Target shares delivered is stuck with a majority interest in a Target; under current Delaware law, the Buyer then must call a special stockholder meeting and prepare a proxy statement solicitation. The SEC reviews the proxy statement, which is then mailed and sits around for 20 business days so that stockholders may digest its contents. Think 45 to 60 day delay prior to actually assuming whole ownership of the Target. The absurd part of this Kabuki theater, however, is that the actual vote is a fait accompli – as long as the Buyer does not discriminate against the remaining minority holders on price, it is perfectly legal for Buyer to vote the shares of Target it acquired from the closing of the tender offer in the subsequent stockholder vote under the proxy statement solicitation. Since the Buyer by definition will at that point hold a majority of shares, absent any supermajority voting provision in the Target’s certificate of incorporation (which would be unusual and in any event would result in a higher than 50 percent condition to close on the underlying tender offer), the Buyer knows before it even mails the proxy statement that it will succeed in the stockholder vote. All that happens in the back-end proxy statement proxy solicitation is a significant chunk of additional professional services cost and, frankly, wasted time.
Perhaps more importantly, certain Buyers are loath to risk owning a majority, but less than 100 percent interest, in a Target for the 60-day period until the vote closes. In particular, financing sources for private equity firms shy away from perceived risks (it is hard to securitize 51 percent vs. 100 percent). However, such private equity firms and their financing sources are perfectly fine with the relatively short (one or two day) period for a 90 percent or greater short-form merger.
There have been all sorts of ingenious en-runs around the Delaware 90 percent requirement to address these challenges. The top-up” option is a clever piece of creative legal structuring in which, at the time of signing an agreement to launch a friendly tender, the Target agrees to issue shares to the Buyer to help the Buyer get above 90 percent. If the Buyer comes in just shy of 90 percent (say 89 percent), then the Buyer will directly purchase from the Target the extra 1 percent in completely newly issued shares (it turns out to be materially more than 1 percent to account for the additional dilution incurred in the purchase) to get to 90 percent. There are various judicial views on how low a percentage (85 percent?) the Buyer can go before the top-up option is problematic – but it is usually is constrained by some sense of a smell test in judicial precedent coupled with the maximum authorized shares available under the Target’s pre-deal certificate of incorporation.
The top-up option is so substantively illusory that Delaware courts have had to intervene to remind participants that, for the top-up option to be valid, an actual exchange of funds from Buyer to Target needs to take place pre-closing to purchase the additional newly issued top-up shares. Buyers (and Targets) had become complacent, so much so that they had at times deemed that, since the Buyer was buying shares of a Target that the Buyer was about to wholly own (along with any cash of the Target, including cash from exercising the top-up option shortly before closing), then it seemed too much trouble to actually wire the purchase price for the top-up shares.
The top-up option may address the “we are almost there” problem to get from, say 88 percent to 90 percent, but it simply is no help in the “we are nowhere near” challenge of, say, 55 percent. Strategic acquirers (i.e., operating companies) may view the top-up option as merely convenient, but private equity firms viewed the yawning gap pf the 50 percent to 85 percent tender range as a death knell for the tender offer: on its own it is reason enough to go down the proxy statement path. In 2010, some creative lawyers entered the fray, fashioning a novel structure for private equity firm 3G’s acquisition of Burger King. It was a whopper of creation: Buyer and Target wrote into the acquisition contract that they agreed to a tender offer – but if a tender offer failed, then a proxy statement process would immediately launch, all while both parties remained under the merger contract. Since then, this structure has spread like wildfire.
The Burger King structure, and that of its slightly refined progeny, loads a gun just in case. While the tender offer is being prepared and launched, a parallel legal team can prepare a preliminary proxy statement and file it with the SEC to get through the pre-review process. If the tender offer fails, then the trigger can be pulled for the proxy statement.
After the Burger King deal, some transactions went too far for the SEC, in that the Target not only filed a preliminary proxy statement, but, after clearing Staff comments, actually went ahead with filing a final proxy statement while the tender remained outstanding. However, this tendency was reined back in a bit (you cannot have two solicitations final and under way at the same time. The chief of the SEC’s Office of Mergers and Acquisitions recently noted that it is perfectly fine to continue to file a preliminary proxy statement in order to clear Staff comments while the tender offer is under way.
Enter stage left the Delaware Bar and proposed Section 251(h) of the Delaware General Corporation Code (DGCL), as submitted in March 2013 for consideration by the Corporate Law Section of the Delaware State Bar Association. In most states, an analogous committee would be a forgotten sleepy hollow– but in Delaware, home to almost as many corporations as people, this body is a driving and powerful commercial force. With an enormous corporate presence, Delaware has a big incentive to maintain an efficient business code that does not create head-scratching questions, such as: what is the point of the 90 percent threshold in situations where the outcome is pre-determined? Hence the simplicity of proposed Section 251(h): it essentially just lowers the 90 percent requirement for a short-form merger to 50 percent, subject to certain basic conditions.
The adoption of Section 251(h) is not set in stone, but, given its prominent backers in the Delaware Bar, it looks likely to enter effect. Once getting past the few procedural requirements of the proposed statutory change (such as non-discrimination on price), its only truly substantive hurdle applies to a small minority of situations in that in order to use Section 251(h), a Buyer cannot be “interested” as that term is defined under Delaware law – which means it cannot have owned more than 15 percent of the Target prior to entering into the acquisition agreement. But in the vast majority of public company acquisitions, private equity firms and strategic acquirers alike will be able to take advantage of a lower threshold.
This all begs the question: what will be left for the beleaguered proxy statement? All cash deals seem destined for the tender offer structure, leaving behind their stock-for-stock acquisition cousins as the exclusive domain of strategic acquirers who have stock to use as currency in a transaction. In these situations, a stockholder vote is almost always required of the Buyer and having to suffer the timing delay of a joint proxy statement is the only alternative.
Section 251(h) threatens the existence of the top-up option. Changing the top-up option in parallel to get to a 50 percent rather than 90 percent threshold based on case history would seem preordained for Delaware judicial doom. The new code section also renders the Burger King structure irrelevant. Who needs a proxy statement back-up plan if whole ownership from a successful tender becomes a foregone conclusion?
Some skeptics have questioned whether this legislative development will lead to stockholder apathy: if a future tender offer appears to be a foregone conclusion, then not enough stockholders may bother to tender – wrecking the deal and meaning it was not a foregone conclusion after all. Section 251(h) proponents respond that institutional holders dominate voting in public company business combinations; once institutions make a decision, they (or their broker) merely need to flick a few fingers through Depositary Trust Company’s computerized Automated Tender Offer Program system to arrange to tender their shares – hardly enough disincentive to justify apathy among professionals.
Negotiation fatigue is an age-old problem in completing any contract – and often, whether fair or not, the further back in the document the clause is positioned, the greater the fatigue.
A choice-of-law provision, which decides which jurisdiction’s law shall govern the contract, is almost always near the last clause in a contract. How often have dueling sets of lawyers (and more frequently, frazzled and puzzled clients who simply want a contract done before the end of the quarter) exhausted themselves on other provisions, only to trade away choice of law for a perceived gain elsewhere in the document?
Delaware Vice Chancellor Donald Parson’s February 22 decision in Meso Scale Diagnostics vs. Roche Diagnostics (Delaware C.A. No. 5589-VCP) highlights how important this seemingly mundane provision can be years later in a change-of-control situation. It also highlights a potentially critical divergence between Delaware and California state law.
Because most California technology companies are incorporated in Delaware, Delaware often is seen as a harmless compromise in choice-of-law provisions, particularly when the counterparty is located in another state, because such counter-party may also be incorporated in Delaware, or overseas, where Delaware’s reputation for business efficiency may be known.
However, electing to use Delaware law may be good for a counterparty undergoing a change of control – and less than optimal for a counterparty that believes it may have negotiated for protection in case the other side in the contract is acquired (for instance, by a competitor).
At specific issue in Meso Scale was whether generic language prohibiting an assignment of the contract (including by “operation of law”) is triggered if a reverse triangular merger is consummated, which is the mechanism by which the vast majority of mergers are structured. In this paradigm, a wholly owned shell subsidiary of a buyer parent corporation merges with and into the target; the target company thus survives intact and it becomes a wholly owned subsidiary of the parent post-closing. To avoid the potential ambiguity of this structure’s effect on a third party’s contract with the target company, sophisticated parties often specifically insert provisions into agreements requiring a consent in the event of a “change of control” in the contracting entity, i.e. the target company, or any corporate parent entity. The Meso Scale case examines what happens when such specific language has been excluded.
This question is important in mergers where triggering an anti-assignment clause may entail either seeking the counterparty’s consent (i.e., customer, supplier or IP licensor’s consent) to the transaction pre-closing, thereby resulting in potential delay as well as lending considerable leverage to the counter-party, or the buyer assuming risk that the contract (which may be instrumental to the operation and thus value of the target business) is invalid post-closing.
In Meso Scale, Vice Chancellor Parsons first affirmed that in Delaware a reverse triangular merger is not considered an assignment, including “by operation of law.” Equally interesting is that he further parsed through California law to demonstrate how California cases would seem to indicate a general assignment clause (with or without “by operation of law” verbiage) is in fact triggered by a reverse triangular merger. In particular, he cited the unpublished 1991 Northern District of California federal court decision in SQL Solutions vs. Oracle Corporation (1991 WL 626458) in which the federal court applied California law to declare that a reverse triangular merger constitutes assignment. Absent a future specific California state court case on the subject to add clarity, it remains uncertain that contracting parties using California law should assume that general anti-assignment clauses will be triggered by reverse triangular mergers.
The learning points from Meso Scale are as follows:
(1) When negotiating contracts, in order to gain full consent protection in a change of control, include explicit, actual language that the contract is void on a change of control of the contracting entity. Such standard language captures the reverse triangular acquisition context. This means a slightly longer contract, but also a clearer understanding between both parties up front, rather than confusion years later when an acquisition of one party is under way. If avoiding a change-of-control clause is absolutely necessary in order to convince the counterparty to enter the contract, then evaluate the choice of law and its repercussions on future assignment.
(2) When involved in a potential change of control, continue to keenly evaluate contract consent provisions – and the choice of law of these contracts. Such diverging terms can mean the difference between an awkward pre-closing consent process (or worse, the scuttling of a deal) and a smooth and speedy closing.
Are you considering bidding for a public company? Has your public company received an acquisition bid? What should you do?
Public/public mergers are highly choreographed affairs within confined boundary conditions dictated by Delaware judicial decisions on the subject – to the extent a deal strays past such guardrails, it is subject to close scrutiny by both plaintiff’s lawyers and judges in Delaware.
This article is a basic entry-level primer for those unfamiliar, or rusty, with public company mergers. These are general themes, and this list is not a substitute for review by knowledgeable counsel. Our goal is to look at some of the events most often encountered in the process of bidding for a public company.
High probability of litigation: In recent years, more than 80 percent of public/public mergers have been subject to Delaware lawsuits – most of these stemming from purportedly deficient disclosure in publicly filed documents. Key areas are the background events to the transaction or the financial metrics and others focusing on conflicts of interest. More substantive suits often revolve around process – how and why a Target board weighs competing offers or whether it is made aware of conflicts of interest. Accordingly, there is great incentive to listen closely to Delaware judicial precedent as well as SEC guidance.
There is a Buyer. And a Target. Although “mergers of equals” exist as an academic term, they rarely come to fruition. That said, while there is always a larger company and a smaller company, board composition of the combined company can be subject to negotiation. And in a case where a Target’s board has no appetite to sell at a given price, then, to avoid the entreaties of a prospective Buyer, the Target’s board must rely upon sound business reasoning – not merely knee-jerk indignant intransigence.
Confidentiality agreement/standstill: Before anything is discussed with the other party, there should be a confidentiality and standstill agreement in place. This protects each side from having its confidential information used against it if negotiations break down. When coupled with a standstill (which, among other things, prohibits each party from buying the stock of the other party in the open market), the agreement prevents a party from going hostile and only effecting a deal through a negotiated transaction with the board. This agreement is absolutely vital (and completely standard) to protect a smaller Target from being bullied in the future.
Timeframe/structure: There are two routes to do deals, both of which are subject to detailed SEC rules. The ordinary public/public merger would be a “reverse triangular merger” in which Target is merged with and into a shell subsidiary of Buyer, and this Target survives post-closing as a wholly owned subsidiary of Buyer:
Tender offers are potentially the quickest avenue to closing a deal. If it is clear that enough of Target stockholders are likely to tender their shares to get to the minimum threshold of either 90 percent of outstanding shares (thereby enabling a short-form merger in Delaware without further approval) or a bit lower percentage where a top-up option kicks in (generally 80-90 percent – this triggers an option, based on authorized shares outstanding, to allow the Buyer to “purchase” additional shares of Target – but where such money is essentially just round-tripped at the closing), then a tender offer may take a week post-signing of an acquisition contract for the drafting/filing of disclosure documents, and 20 business days for mandatory consideration by stockholders. Tender offers often do not receive as many SEC comments and do not usually require recirculation of disclosure documents as a result of comments (or restarting of the tender clock). If a deal fails to achieve 90 percent of Target’s outstanding vote tendered (or the top-up percentage), but does get at least 50 percent of Target’s stock tendered, then often a Buyer will buy the majority position and then call a special stockholders meeting where it will force a merger that squeezes out the remaining minority stockholders at the tender price. This additional step can add up to 60 days to the process in order to call the special meeting and mail a proxy statement.
Proxy solicitations for a special stockholders meeting are the most sure way of ensuring deal consummation in one step – as long as 50.1 percent of the shares of the Target vote in favor of a merger, the merger can be immediately consummated. However, proxy statements for special meetings often receive greater SEC scrutiny and, unlike with a tender offer, disclosure documents cannot be finalized/mailed until the SEC’s review has been complete. The process may take 15 or more days longer than a tender offer – while this period at first blush may seem small, it can actually appear an eternity to a Buyer if alternate bidders are in the wings and possibly engaged in a post-signing bidding war with topping bids.
Proxy solicitations used to be the preferred alternative to tender offers, but since the SEC clarified tender offer regulation around the best price rule last decade, tender offers have surged back and are favored for their speed of execution by strategic (non-private equity) Buyers. Financial Buyers (private equity [PE] firms) often cannot do a stand-alone tender offer becausetheir debt financing sources do not like the prospect of a non-wholly owned Target if only 50.1 percent is reached, even if only for a brief time until a special meeting can be held. In recent years, however, a hybrid dual structure for PE firms also has emerged whereby a Target agrees to a tender offer while simultaneously preparing a proxy statement to be used if the tender offer fails to reach 90 percent or the top-up option threshold.
Documentation: Both structural alternatives require a negotiated, complex acquisition contract (and accompanying disclosure schedule). After executing the contract, a tender offer requires the filing of an offer to purchase on Schedule-TO by Buyer (and Target’s disclosure on Schedule 14D-9), whereas a merger agreement requires a Form S-4 registration/proxy statement which registers the deal consideration stock (if applicable) and contains the stockholder meeting disclosure for Target (and Buyer where applicable due to Buyer stock consideration in excess of 20 percent of Buyer’s capitalization).
Due diligence: A cash deal will require diligence by Buyer on Target, but not vice versa. Conversely, a deal in which the consideration is only, or in part, Buyer’s stock requires “reverse” diligence by Target on the Buyer. Large deals with well-established companies may take limited diligence since counsel will argue that the public filings are sufficient. On the other hand, a Target that is a small public company with limited leverage may be required to produce extensive diligence before the Buyer is comfortable going forward.
Regulatory review: Almost all public company Targets will be large enough to meet the transaction size test for a Hart-Scott-Rodino (HSR) anti-trust filing. Assuming no substantive issues, a transaction is normally approved within about 45-60 days (which runs simultaneously, and often co-terminus, to the tender offer and proxy statement timeframes listed). Either US or foreign (EU or unique jurisdictions) anti-trust issues have the potential to cause delay.
Board role: For Targets, outside directors have a key role in any change of control. Best practice is to have the Target board immediately appoint a committee of three (or so, but more than that number can become unmanageable given the tight timeline and need for availability) to essentially run the process. This is not a strict “special committee” which is a term of art for a highly regulated situation where the Target is being taken private by management or other conflicts of interest exist.
A transactional committee of convenience allows for a smaller group of directors, generally those on the Target board who are independent but also deal savvy, to supervise the process and make nimble tactical decisions while protecting against any appearance of conflict of interest by management. In fact, any change of control discussions, no matter how seemingly nascent or exploratory, should be vetted with and directed by the Target board (or its transactional committee) and any management to management discussions about future management composition or compensation should definitely be avoided; no matter how generalized or routine such communication may appear at the time, they can be made to seem inappropriate in retrospect.
Financial advisors: A “fairness opinion” from an investment bank (IB) will be advised under Delaware practice to be delivered to the Target stockholders (and in some cases a separate IB will need to deliver an opinion to the Buyer stockholders). The majority of IB fees are contingent upon closing. Bankers are very useful in both negotiating upfront, as well as lending credibility for the record (again, litigation protection). For example, in a stock-for-stock deal, there always is the question of whether “collars” (prescribed ranges in which the shares of each company can float prior to closing without creating a termination right)are appropriate. The earlier there is a selection ”bake-off” and bankers are involved, the better.
Track the process: Make note of all meetings and contacts (including via telephone) between management teams, boards and outside advisors – with just time/date/place and general description. Such a timeline becomes crucial when drafting disclosure documents, or, unfortunately, if litigation arises.
Secrecy: Confine knowledge of this activity to a small group – the circle of trust will need to expand in tranches over time, but initially, it need be only a couple of folks. Public leakage is dangerous as it may drive up the Target’s pre-signing trading price and thus erode the sizing-date price premium, which can be optically problematic even if the historical trading averages indicate a healthy premium. In addition, after a transaction closes, stock exchange regulatory authorities routinely poll participants at both Buyer and Target, as well as their legal and financial advisers, with lists of stockholders who traded immediately prior to the announcement of a deal, in order to police insider trading.
Managing leadership succession in the misnomered “merger of equals” or the more common combination of two large public companies of different sizes can often be tricky. To the extent that both the buyer and the target agree that one or more members of a target’s management team are to transition to management positions in the combined company, merger contracts often specify who shall become what.
But such provisions are rarely drafted to be effective for any period of time beyond the closing. Further, buyers are loath to have a target’s stockholders become third-party beneficiaries to a merger contract between the buyer and the target and thereby give individual target stockholders, and the plaintiff law firms who may eagerly seek out such individual stockholders, standing in court to sue.
As a result, if management positions are not apportioned as contemplated in the merger contract, there is not necessarily anyone left following the closing to pursue the buyer. Buyers are equally hesitant to delegate authority over future management decisions to some sub-set of legacy target directors, an act which would thereby cede outsized power over management selection to a minority of the merged company’s board.
The circumstances in the merger of Duke Energy and Progress Energy – titans in the Southeastern energy production market – illustrate the awkwardness of such arrangements. On January 10, 2011, Duke and Progress announced their proposed marriage with an all-stock dowry for Progress valued just shy of US$14 billion. Two eminently reputable law firms were involved: Wachtell, Lipton Rosen & Katz represented Duke, while Hunton & Williams represented Progress.
Section 1.07(b) of the merger contract stipulated that:
Duke’s Board of Directors shall cause the current Chief Executive Officer of Progress (the “Progress CEO”) to be appointed as the President and Chief Executive Officer of Duke, and cause the current Chief Executive Officer of Duke (the “Duke CEO”) to be appointed as the Chairman of the Board of Directors of Duke, in each case, effective as of, and conditioned upon the occurrence of, the Effective Time, and subject to such individuals’ ability and willingness to serve.
The CEO of smaller Progress thus was to become CEO of the combined company. The combined board of 18 consisted of 11 directors from Duke and 7 from Progress.
Following a lengthy regulatory approval process, the merger closed on July 2, 2012. In the corporate equivalent of a nanosecond after the closing – reportedly about 20 actual minutes – the Duke directors unanimously voted on a conference call to oust the “current” CEO (from Progress) and bring back Duke’s CEO. As best understood from media reports, all five legacy Progress directors present on the call voted against this change, but to no avail. The Progress CEO officially ”resigned” from the combined company effective midnight on July 3 and was sent packing, with a not-too-shabby total severance package worth US$44 million.
Progress was based in Raleigh and Duke in Charlotte. Following the deal, the members of the North Carolina Public Utilities Commission publicly decried what they believed was an outcome different from what had been presented to them. They quickly hauled in the parties to explain, thereby granting deal observers a rare expedited view of the boardroom tactics in this transaction.
Accusations from Duke (of a supposedly dictatorial but also hands-off Progress CEO) who purportedly fumbled with issues at the company’s nuclear plants – cracked containment structures can be a costly thing as Duke continues to discover) and counter-accusations from the CEO of Progress (that Duke got cold feet about the deal price, leading to eagerness to avoid a closing and sudden antagonism toward the leadership at Progress) have flown. While it remains hard to separate the wheat from the chaff, ultimately, absent a giant, and unjustified, governmental intervention from the North Carolina PUC, it seems likely the ouster will stand. Two legacy Progress directors have already resigned in a huff.
One cannot really fault Duke. As buyer, it lived up to the Spartan terms of the merger contract. And, as Duke’s old (er, new) CEO was quick to point out, the post-closing board had a fiduciary duty to change leadership if they believed in good faith that the Progress CEO was no longer the best leader.
Could anything have been drafted contractually by Progress pre-signing to avoid this predicament? In private company mergers, the answer is simple. A voting agreement could have been executed as a condition to closing under which large stockholders would agree to vote in favor of board nominees who support a particular management member or team, or at least allow legacy stockholders a blocking right (probably with the usual ”reasonableness” proviso). That voting agreement could not be amended without the consent of the stockholders or board members from the smaller target company.
However, because of the large turnover in a public company’s stockholder base, public company voting agreements (absent a large majority holder or the like) are not feasible, just the same as with public company escrow distributions. There are other exotic potential ways to address this issue. One could hypothetically connive a dual-class structure with separate voting or blocking rights for management. But that is impractical as well as unrealistic – the complexity far outweighs the potential problem.
What about the actual merger contract? To prescribe a given minimum time (six months? A year?) for the new CEO to have an essentially unfettered right to remain in place is thorny in and of itself. If anything, it creates the ideal conditions for a lame-duck CEO who can operate with impugnity. More important remains the issue of standing. Any buyer almost certainly would reject such a third-party beneficiary clause outright.
An interesting example of another path that could be taken is the combination of United Airlines and Continental Airlines, first announced in May 2010. Its merger contract specified that the CEO of United would become chairman of the board of the combined airline for two years, while the CEO of Continental would become CEO of the combined company and eventually chairman of the board. In contrast to the Duke/Progress transaction, and despite size inequalities in the two companies, the board of the combined company was much more evenly drawn – seven members came from each company and two were union representatives. There is no indication that United regretted this setup – in fact, to the contrary, commentators indicated that United viewed a pivotal part of the Continental deal as the ability to tap the talent of a dynamic and young Continental CEO to help chart the troubled waters of commercial aviation. One wonders: if Progress had the leverage (or fortitude) to insist on a more evenly cleaved successor board for its deal, à la United/Continental – and if it had, whether the same leadership outcome would have ensued. We have no way of knowing (at least as of yet) how much the dueling sets of counsel and business principals negotiated the CEO provision and the board composition pre-signing.
Lest the Duke/Progress situation seem one of a heavy-handed Goliath adhering to a narrow and strict legal duty under the merger contract with nary a second thought, it is worth considering the practical, non-legal disincentives that would dissuade a buyer from casually ejecting a CEO immediately post-closing. Specifically: (a) no board wants a public food fight immediately following closing, thereby inviting intense scrutiny from both media and regulators; (b) the Progress CEO’s US$44 million severance package, while dwarfed by the roughly US$30 billion market capitalization of the combined company, was a hefty payout; and (c) any level of enmity and mistrust among the remaining directors (even if two of them quickly bid their indignant farewells) is clearly sub-optimal.
So, what happened in Duke/Progress? A public company buyer is a buyer. A “merger of equals” or a “partnership” are wonderful terms for branding and employee morale post-integration, but unfortunately a bit feckless from a purely legal leverage analysis. The Duke/Progress deal highlights yet again the benefits of the control premium. Legacy Duke directors controlled the board and did what they thought best. The Progress board had every opportunity to alter the board balance as part of its pre-signing contractual negotiations. But any pre-signing reassurances from the buyer, no matter if made in entirely good faith at the time, should not dissuade a target’s board from the reality that control means control. And rightfully, the sanctity of a contract is most often unimpeachable.
Shareholder Approval of Small Private Acquisitions:Has Omnicare Been Rendered a Farce?
By Ed Batts, a Partner of DLA Piper
Deal Lawyers, March-April 2012
Perceived Delaware requirements for stockholder solicitation to approve an acquisition agreement have become increasingly opaque due to first the 2003 Omnicare decision and then the subsequent erosion thereof. The result is the casting of a cloud of both uncertainty and inefficiency, the twin root evils of effective corporate jurisprudence.
In Omnicare Inc. vs. NCS Healthcare Inc., 818 A.2d 914 (Del. 2003), the Supreme Court of Delaware invalidated a merger agreement where an insolvent company had been given 24 hours by a potential acquirer to agree to (1) no fiduciary out (the ability by a target company to terminate the agreement, subject to a break-up fee, in the event a third company offers a superior proposal for the target company) and (2) requiring voting agreements from two stockholders, who also represented one half the board, which had the effect of contractually guaranteeing the required stockholder vote prior to the company actually submitting the deal for approval to the stockholders as a whole.
Prior to Omnicare, private company acquisitions were relatively straightforward affairs. Provided that a transaction’s value fell below the threshold requiring a Hart-Scott-Rodino (HSR) antitrust notification filing (currently around US$66 million), and that consents from customers or suppliers could be acquired prior to signing, often a buyer could insist on a simultaneous signing and closing whereby stockholder consents were delivered concurrent with execution of the merger agreement. In venture capital backed companies, with a concentration of share ownership in a select few VC firms and perhaps a founder or two, smaller stockholders were routinely ignored in the initial pre-execution solicitation, though they retained the dissenters’ rights accorded them by statute. While this may seem procedurally high-handed, it did nothing to substantively change the outcome of any merger vote.
A simultaneous sign/close was beneficial, however, in that it allowed certain verbose, contentious provisions to be omitted from a merger agreement—for instance, interim operating covenants for the target company between signing and closing, a termination section, fiduciary outs and break-up fees. Omitting such provisions increased deal certainty and reduced transactional (that is, lawyer) costs. Even when HSR filings or contractual consents were necessary, the immediate delivery of stockholder approval at signing eliminated the buyer’s fear of a deal break-up from topping interference.
The decision in Omnicare limited the ability to lock up a deal prior to its submission to stockholders following execution of an agreement. For public company transactions, it meant that voting agreements could no longer make a deal a forgone conclusion. And, indeed, it meant the same for private company transactions—but with the added wrinkle that a period between signing and closing became mandatory, not optional. Thus came the advent of interim operating covenants and termination provisions in private company agreements, even where no HSR filing or contractual consents were required.
Following Omnicare, some counsel in smaller transactions quite conveniently chose to ignore the decision—and in such deals many continue to do so. Some cannot be bothered to worry about the purportedly hypothetical risk of merger contract judicial invalidation; others stake their claim by asserting that the specific facts of Omnicare are not analogous to a concurrent sign/close situation.
The oracles of the Delaware Bar, however, have generally taken a dim view of both perspectives. The risk of stockholder litigation in a closely held private company may be remote, but many are concerned about even the faint chance that a cranky shareholder might turn up in a Delaware court to upset a merger. And while the facts of Omnicare are extreme (an insolvent corporation backed into a financial pickle) the underlying holdings are pretty clear-cut—at least on their own. Further, if a law firm is asked to give a legal opinion on enforceability of a merger contract that does not comply with the basic tenets of Omnicare, ignoring the case is a difficult proposition.
From a public policy standpoint, the roots of Omnicare may well be grounded in laudable goals. In Omnicare, the target company (NCS Healthcare) was jammed. It was given less than 24 hours to deliver a stockholder vote for deal that threw a lifeline of value to an enterprise precariously perched on the precipice of financial apocalypse. One could reasonably posit that stockholders should have a fair period of time in which to review a detailed solicitation statement. The majority opinion in Omnicare noted there is an inherent balance under Delaware law between the board and the stockholders. Restoring some period of reasonable review would seem equitable in allowing stockholders to offset the specter of unfettered board edicts. Public companies already in reality enjoyed such benefits as federal securities laws have long mandated that a proxy statement for a publicly-traded company must be in the mail no later than 20 business days prior to a stockholder vote, giving stockholders a whopping month to mull over a deal’s merits.
Omnicare, however, has been muddied by subsequent erosion. Nothing in either that decision or in Delaware law prescribes an actual bright-line time period for stockholder review of the terms of a proposed merger. In practice, many deals now involve execution of the merger agreement followed by an immediate “solicitation” that constitutes an e-mail from the target’s counsel to stockholders, followed by the seemingly magical submission of stockholder consents from large stockholders representing the required vote. Such consents in reality often are sought in hushed tones by the target’s counsel prior to the execution of the merger agreement and held by such counsel in mythical escrow, pending signing.
This process perfects the triumph of form over substance. It therefore was inevitable that some clever lawyer would impose a post-signing deadline for a stockholder vote. Such a deadline was included in a merger agreement that became the subject of a 2008 Delaware Chancery case, Miami v. WCI Steel, Inc., C.A. No. 3833-VCL (Del. Ch. June 27, 2008), in which a 24‑hour deadline to return consents was included in the merger contract; the failure to meet such condition gave the buyer a right to terminate. Upholding this condition, Vice Chancellor Stephen Lamb reaffirmed that Delaware law does not require “any particular period of time between a board’s authorization of a merger agreement and the necessary stockholder vote.” WCI Steel thus would appear to substantially undermine Omnicare’s applicability to private company mergers.
Indeed, following WCI Steel, many smaller private company agreements now contain a 24-hour (or shorter) deadline, whereby the buyer can terminate the agreement if the stockholder vote has not been received.
The result is farcical. Frantically prepared solicitation statements are transmitted in a post-signing e-mail flurry, only to be promptly superseded by prepared consents, freshly released from “escrow” and pouring in. However, lawyers must still negotiate pre-closing operating covenants, and termination provisions all of which are an arguably superfluous chore if no HSR or contractual consents are needed for closing; the provisions themselves remain operative only during the briefly open window between signing of the merger agreement and the return of stockholder approvals just hours later. One could hypothetically assert that WCI Steel allows for a return to the old days of near-simultaneous signing/closing, but it is not clear that it does. And lack of clarity causes customarily risk-averse lawyers to assume that the worst (a court
action to invalidate) can still occur. For a transaction of modest size, this imposes both needless angst and an indirect tax (of lawyer’s fees) on stockholders of both sides of the transaction.
The unadorned beauty of Delaware as the jurisdiction of choice for American corporate law is its large body of rulings on the subject, its speedy opportunity for judicial review, its customer-service oriented filing process (the utility of which is not to be underestimated) and the (usual) clarity of its judicial guidance.
A few larger technology darlings have recently conducted long-awaited IPOs which have garnered much publicity. However, such deals are numerically dwarfed by the volume of pre-public acquisitions. Well established, large technology companies rely on Silicon Valley and its various geographic siblings as incubators for ideas that are enshrined in an ever-changing constellation of startups. The ability to efficiently and quickly acquire such idea-based entrepreneurial gems strips away development cost. And even startups (and their VC backers) rely on the ability to quickly combine such very entities in order to re-jigger organizations, tweak development and evolve ideas.
Accordingly, Delaware, whether through one of its august judiciary or legislative bodies, would do well to proactively address the present conundrum. If Delaware decides, through statute or a bright-line Supreme Court holding, to require a minimum period of time for stockholder review, then so be it—but a public policy determination of such import needs real teeth. One would think a period of 72 hours reasonable to digest and discuss the contents of a thorough solicitation statement (which Delaware also ought to consider mandating be written in “plain English”). In larger transactions with publicly traded buyers, even though there likely would be a required HSR filing, 72 hours would seem a reasonable period, since such buyers may need to file the terms or actual agreement on a Form 8-K with the Securities and Exchange Commission. Such a filing publicizes the commercial terms of the deal, thereby essentially inviting topping offers, permissible absent stockholder approval ending a fiduciary out period, which such buyers are understandably loathe to do.
What we do not need is the current, de facto standard, in all its ambiguity and ridiculous brevity. On the other hand, if Delaware decides that no prescribed period is necessary, and the power of stockholders to withhold their vote (or signature on a consent) is sufficient leverage in the balance of the board and the stockholders with which Delaware should not further interfere, so be it. Such a clarification would allow the charmingly simplistic simultaneous sign/close model to re-emerge.
With either approach, however, at least transactional lawyers in small private deals could abandon their perennial head-scratching question: “But what about Omnicare?”