MERGERS AND ACQUISITIONS Fall 2012 Professor Shaner

Shareholder Primacy Shareholder primacy advocates believe that the best interest of the corporation should be framed as the best interests of the shareholders. Therefore, the purpose of corporations is to establish organizing principles under which S/Hs can conduct the enterprise for their own benefit. Bebchuk believes that increasing shareholder power is desireable and potentially feasible without undermining the important managerial role of directors. The purpose of this share holder empowerment is to increase corporate performance. Director Primacy Under the director primacy model, the BoD are not agents to S/Hs. Rather, it serves as the nexus of the various contracts that make up corporations, including contracts with S/Hs, creditors, employees and other stakeholders. Here, S/Hs are not considered owners of the corporation because a corporation is not an entity that is capable of being owned. Therefore, shareholder participation is not necessary for a successful corporation. Shareholder participation under the director primacy model serves as a form of corporate governance in which the S/Hs contract for what they want by deciding which companies they will invest in. His argument is that if S/H empowerment were value-enhancing, it would already exist in the marketplace. EVERYTHING ELSE The DE SC uses six basic tests for judging the actions of a BoD in an acquisition: 1) the BJR applied in Smith v. Van Gorkum, 2) the reasonableness and proportionality test of enhanced BJR under Unocal which applies when a target adopts defenses to a hostile bidder, 3) the best price on sale of control test established in Revlon, 4) the compelling justification standard under Blasius, 5) the coercion and preclusion test under Unitrin, and 6) the waste and entrenchment test under Cheff v. Mathes. Essay DE law has established different standard of conduct requirements for directors in varying circumstances. The courts apply a different standard of review based on these differences. The basic standard of conduct for directors is that they must act in good faith and in a manner the director reasonably believes to be in the best interests of the corporation. Informed Decisions: Breach of Duty of Care In a merger or acquisition context, the initial standard of review for a directors conduct is the business judgment rule. The BJR protects decisions of the BoD from being second guessed by courts and protects directors from personal liability if the decision turns out to be a bad one. However, to be governed by the BJR the decision must be disinterested, informed and made in good faith. In Smith v. Van Gorkum, the DE SC held that the BJR does not apply to the BoD in negotiating a merger if the directors are interested, do not act in good faith, or reach their decision by a grossly negligent process. In Smith, the BoD approved a cash-out merger of Trans Union at the behest of Van Gorkum, the CEO. The BJR was held not to apply to the BoDs decision because the BoD was grossly negligent (and therefore breached its duty of care) in accepting the merger agreement based on a 20 minute oral presentation from the self-interested CEO without their regular investment bankers present and without actually reading the document. When the BJR is not available, the DE courts evaluate the merits of the deal under the entire or intrinsic fairness test which places the burden on the BoD to show that the transaction was fair. Entrenchment Many of the merger and acquisition cases address the underlying fear that directors act in ways that help entrench themselves in office. Directors of a company develop firm specific skill, such as understanding the strengths and weaknesses of the employee staff, that are not transferable in the marketplace. This creates an incentive for the directors to take actions that help them retain their office and capitalize on these firm specific skills. This incentive was part of what the DE SC addressed in Cheff v. Mathes, In Cheff, Maremont purchased a large block of Holland stock and demanded to join the BoD with the likely intention of taking over and liquidating the company. The BoD decided to repurchase the stock with corporate funds and bought back Maremonts stock at a pemium. The court in Cheff recognized that there is an inherent conflict of interest when a corporation purchases its own stock in order to revoke a threat to corporate control because the BoD may be acting to entrench themselves in office. Therefore, the BJR only applies if the BoD decision to prevent the takeover using corporate funds if it was done 1) in good faith, 2) with reasonable investigation, and 3) was justified by a valid business purpose. Therefore, the BoD has the burden of proving reasonable grounds to believe a danger to corporate policy existed. The showing of employee unrest and Maremonts history of liquidating companies was sufficient to justify the BoDs belief that a threat existed. Similarly, in Johnson v. Trueblood, the court held that to survive a BoDs motion for a directed verdict on the basis of entrenchment, the plaintiff must show that the sole or primary motive of the BoD was to retain control. Therefore, if there is a preponderance of evidence suggesting that the BoD acted solely out of a desire to retain control, the BJR does not apply.

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Enhanced Judicial Scrutiny: Defensive Measures - Unocal These entrenchment cases set the stage for Unocal, which created an enhanced judicial scrutiny standard of review for defensive measures taken by the board during a hostile takeover. (Although certain scholars such as Bainbridge would argue that Unocal is simply a conditional version of the BJR, not an enhanced scrutiny standard). Under Unocal, the inherent conflict of interest of a BoD in a hostile takeover situation requires that the BoDs conduct satisfy a two-part test before the BJR applies. First, the 1) reasonableness prong requires that the BoD have reasonable grounds for believing that a threat to corporate policy exists. This is satisfied by showing good faith and reasonable investigation and is enhanced by proving that the decision was recommended by independent directors. Unocal; Panter v. Marshall. Second, the 2) proportionality prong requires that the BoDs defensive response not be draconian (preclusive or coercive) and is reasonable in relation to the threat posed. If the BoD does not satisfy either of these prongs, its conduct is evaluated under the entire fairness standard. In Unocal, Mesa was attempted a hostile takeover of Unocal using a two-tier front-loaded cash tender offer. The court held that the BoDs decision to create a self-tender offer that excluded Mesa was based on a valid business purpose and that the action was reasonable in relation to the threat posed because excluding Mesa was the only way to make the plan work. The BoD was not acting solely to entrench themselves. Moreover, the decision was recommended by a majority of independent directors that had solicited the advice of outside bankers. Enhanced Judicial Scrutiny: Sale of Control Revlon While standard defensive measures to protect the company from a hostile takeover are subject to the Unocal version of enhanced judicial scrutiny, the requirements for the BoD change when it becomes clear that a change in corporate control is inevitable. In Revlon v. MacAndrews, the DE SC held that when it appears that an active bidding contest is underway, the BoD is under an obligation to sell the company at the best price reasonably available from a reputable bidder for its S/Hs. The rationale is that once the company is put up for sale, the BoD is no longer faced with a Unocal threat to corporate policy. Therefore, the issue of whether the defensive measures are reasonable in relation to a threat to corporate policy becomes moot. In lieu of a threat to corporate policy, the BoD duty to the S/Hs is to get the best price or best value for the S/Hs rather than worry about the long-term potential. Therefore, the court in Revlon held that the defensive measures given to the white knight (including a no-shop clause, a lock-up option, and a $25M termination fee) effectively cut off the auction and were detrimental to shareholders. Therefore, while under Unocal the target BoD may block an unwanted bidder under certain circumstances, under Revlon the target BoD must sell to an unwanted bidder if the bidder offers the best value to target shareholders. The classification of whether Unocal or Revlon applies can therefore be incredibly important to determining whether a target BoDs discrimination against the highest bidder will be tolerated. Which Standard Applies - Unocal or Revlon? Therefore, determining which enhanced judicial scrutiny test, Unocal or Revlon, can be crucial in determining whether the BoD is successful in blocking an unwanted bidder. In Paramount v. QVC, the court held that Paramount put itself up for sale and therefore the BoD had a duty to sell to the highest bidder. The company puts itself up for sale when it initiates an activie bidding process, initiates a sale for cash or any other transaction that would result in a change of control. By contrast, in Paramount v. Time the DE SC held that Time had not put itself up for sale in agreeing to a negotiated merger with Warner. In Time, the BoD had agreed to a merger with Warner after extensive research of the entertainment industry in which Warner would get 62% of the combined companies and the two companies would share control. The Court held that Time was not obligated under Revlon to obtain the best price for S/Hs because they had not put the company on the block meaning that a sale was not a foregone conclusion. Rather, this was a merger of equals. Therefore, the defensive measures adopted by time to protect itself against Paramounts hostile bid were judged under the Unocal standard of review. The Court held that there were reasonable grounds for believing a danger to corporate policy existed and that the defensive measures taken by Time were reasonable in relation to the threat posed. In Paramount v. Time, the court held that Times defenses to a hostile takeover by Paramount were reasonable because the BoD believed that Paramounts offer threatened a previously-negotiated combination with Warner. Additionally, Time was interested in protecting their corporate culture. Similarly, in Omnicare v. NCS, the court held that NCS was not under a duty to auction the company because the stock-for-stock merger between Genesis and NCS did not result in a change of control. Merger Agreement: Deal Protections Merger agreements frequently contain protection measures that serve to 1) provide some value to a purchaser should the target not go through with the deal, and 2) obstruct disruption of the deal by another purchaser. The provisions frequently used include 1) no-talk clauses, in which the target is limited in its ability to provide non-public information to other potential purchasers, 2) no shop clauses, in which the target is restricted from soliciting offers from other potential purchasers, 3) termination fees, which compensate the potential purchaser if the transaction does not close, 4) lock up options, in which an option is granted to the purchaser to acquire stock or assets of the target if the deal does not close, and 5) voting agreements, in which members of the

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BoD that have equity in the target promise to vote in favor of the merger regardless of future bids that may arise after the signing of the merger agreement. Sometimes, these protective measures are weakened by fiduciary out clauses that allow the target BoD to rescind the merger agreement in order to conform with their fiduciary duties to shareholders. Some of these clauses, such as the one in Ace Limited v. Capital Re., require that the BoD receive the written opinion of outside counsel stating that the action they are choosing in conflict with the merger agreement is required to conform with their fiduciary duties. When deal protection measures protect one bidder over the rest, the DE courts apply an enhanced scrutiny review of the protections. Omnicare v. NCS. Generally, to survive judicial scrutiny a BoDs decision to add deal protection provisions that make it difficult for the firm to accept a better offer the BoD must be able to demonstrate that the provisions provided tangible value to S/Hs. Therefore, the issue is whether the use of the provisions provided a benefit or a plausible benefit to S/Hs. Depending on the circumstances, either the Unocal or the Revlon form of enhanced scrutiny will apply. Deal Protection: No Change of Control - Unocal If there is no change in control, the basic BJR applies to the negotiation between the favored bidder and the selling firm. Additionally, the Unocal test applies to any deal protection covenants that deter hostile bidders. However, if a firm has put itself up for sale or there is otherwise a change in control, the BoD must sell to the highest bidder. Therefore, under Revlon the deal protections must be directed at the goal of getting the best value or best price. In Omnicare, Omnicare sought to invalidate a merger agreement between NCS and Genesis. In Omnicare, NCS and Genesis entered into a merger agreement that included a number of deal protection devices including a no-talk provision, a lack of a fiduciary out clause, and a voting agreement in which the majority S/Hs agreed to vote in favor of the merger regardless of any future bids that arose. NCS argued that the clauses were justified because they feared Genesis would walk away from the deal and they were in severe financial trouble (creditors could force them into bankruptcy at any time). The court held that the Revlon test did not apply to the protective devices because the stock-for-stock merger did not result in a change in control. Therefore, the court applied basic Unocal test to the NCS BoDs approval of the deal protection devices in the merger agreement with Genesis. In applying Unocal, the court used the test from Unitrin to determine whether the second prong of Unocal was met. Under Unitrin, the second prong of Unocal is only met if the defensive measures taken (here, the voting agreement used to lock up the merger) were not preclusive and coercive and were in the range of reasonableness. The court held that the voting agreement used to completely lock up the Genesis merger violated NCS BoDs fiduciary duties because they were preclusive and coercive. Moreover, the BoD breached its fiduciary duties in failing to negotiate a fiduciary out clause. in which there was Deal Protection: Change of Control - Revlon If there is no change in control, the basic BJR applies to the negotiation between the favored bidder and the selling firm. Additionally, the Unocal test applies to any deal protection covenants that deter hostile bidders. However, if a firm has put itself up for sale or there is otherwise a change in control, the BoD must sell to the highest bidder. In Revlon, the court held that while lock-up provisions are not necessarily illegal, when they are employed with no other purpose than to prevent competitive bidding and depress the sale price, the lock-up does not benefit for the shareholders and constitutes a breach of fiduciary duty. Moreover, the court held that while no-shop clauses are not per se illegal, they are illegal if they work to the detriment of shareholders. The court acknowledged that certain provisions used to negotiate with a white knight may be justified if the hostile bidders offer is adverse to S/H interests, but when dissolution of the company becomes inevitable the BoD can no longer play favorites. In Ace Limited v. Capital Re, the court held that Capital Re did not violate its merger agreement with ACE by terminating it to pursue a deal with XL Capital. Their agreement included a fiduciary out clause allowing Capital Re to terminate the agreement when the BoD concluded that pursuing negotations with another third party was necessary to prevent breaching fiduciary duties to shareholders. Managers As Buyers When a targets senior managers or BoD have stakes in the acquiring firm, an inherent conflict of interest exists and therefore the BoDs actions must satisfy the entire fairness test. Mills Acquisition Co. v. MacMillan, Inc. In MacMillan, Mills sought to enjoin an asset option agreement between MacMillan and KKR. MacMillans CEO and COO were favoring KKR in the auction providing them with confidential information, tips about competitors bids, and granting them a lock-up option. Moreover, MacMillans Special Committee making recommendations to the BoD was composed of independent directors, but they were all hand-picked by the self-interested CEO. The court held that the BoDs decision did not meet its burden under Revlon to obtain the highest value reasonably available by a reputable and responsible bidder and therefore was subject to the entire fairness test not the BJR. The MacMillan court found the transaction unfair because there was favoritism, lack of candor and deceit. This decision does not conflict with Bainbridges theory of director primacy. When the BoD fails to maximize S/H wealth, Bainbridge supports judicial interference as a means of keeping the directors accountable to prevent breaches of fiduciary duty.

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Additional concerns arise in situations where managers plan to purchase the firm through a leveraged buy-out. Here, management would become owners of the firm by using the firm as collateral to borrow money in the junk bond market to buy out existing S/Hs. Since they are effectively entrenching themselves in office, the Cheff v. Mathes and Unocal concerns arise. In an auction setting in which the BoD must achieve the highest price reasonably available for S/Hs, the BoD must act in a neutral manner. Barkan v. Amsted. Applying a Revlon standard in Barkan, the court held that a management-sponsored LBO negotiated by an independent Special Committed was generally fair to shareholders and that the BoD did not thwart higher bids. When the BoD is evaluating a single offer, with no reliable grounds for judging its adequatcy, fairness requires a canvas of the market to determine if higher bids might be solicited. In re Fort Howard Corp. Shareholders Litigation. However, in Barkan, Amsted had been in play for ten months and no other offers came in. Moreover, the Special Committee was able to negotiate an improved offer even after outside investment bankers said the initial offer was fair. On the other hand, they did not solicit new bids and they enacted an employee stock option plan meant to impede takeovers. Nevertheless, the court held that under the facts in Barkan a full survey of the market was not required for the BoD to approve the transaction. In RJR Nabisco, the court held that the Special Committee exercised good faith and due care and met their burden under Revlon. In RJR, the Special Committee was composed of outside directors, not selected by the CEO. The Committee chose the KKR bid over the management bid, which means the court was not concerned with issues of entrenchment. The two bids were considered by investment bankers to be substantially similar (although the face value of the management bid appeared slightly higher), the Special Committee was not negligent in picking KKRs bid. Perfection in the auction is not required. Single Bidder: Pre-Merger Agreement Auction Not Required In In re Fort Howard Corp. Shareholders litigation, the court held that a pre-merger agreement auction is not required where the directors mechanism to achieve information on potential alternatives puts the BoD in a position to exercise a fully informed judgment. This shows the latitude that BoDs have in following Revlon. A level playing field throughout the process is not required as long as the measures were taken to advance S/H interests. In In re Fort Howard, a Special Committee met their Revlon duties by negotiating provisions (removing termination fees and putting out a press release announcing it would consider other offers that was widely distributed) that allowed it to make an effective check of the market. Even though the Special Committee was hand selected by the CEO, they negotiated better terms, a better price from Morgan Stanley, and reviewed eight other interested parties inquiries. Similarly, in In re MONY Group Inc. Shareholder Litigation, the court held that the board can forego a pre-merger agreement auction in favor of a process that involves a single bidder followed by a post-agreement market check. In MONY, the court said there was no hard and fast rule about what is reasonable for the BoD but that the 5-month postagreement period was adequate for a competing bidder to emerge and the termination fee of 3.3% of MONYs total equity was reasonable. The court held the BoD had achieved the best price reasonably available under the circumstances . Lock-up Agreements in an Auction Lock-up provision is a term that refers to the option granted by a seller to a buyer to purchase a target companys stock or other firm assets as a prelude to a takeover. The major or controlling shareholder is then effectively "locked-up" and is not free to sell the assets to a party other than the designated potential buyer. Lock-up agreements are sometimes used to facilitate the negotiation process by drawing in a potential bidder who would otherwise not be interested. However, lock-up agreements can also be used by an interested BoD to favor a "white knight" for reasons that may not be tied to the best interests of shareholders. Therefore, lock-up provisions are not per se illegal. When employed to prevent a takeover that would be detrimental to shareholders, the BoD may use them. However, if the lock-up has no effect other than to prevent competitive bidding thereby depressing the sale price, the lock-up does not work for the shareholders benefit and their use constitutes a breach of loyalty on the part of the BoD. Disenfranchising Voters There are ways in which directors can inhibit or interfere with shareholder voting rights to help prevent takeovers. Shareholder franchise is a tool of discipline that acts as a counterbalancing force to directors actions and incentives. That is, the BoD can be disciplined through the shareholder right to vote. Bainbridge would argue that we should not undermine the authority of the directors by making it easy for a hostile bidder to bypass the BoD or the BoD loses negotiating power to provide shareholders with the best deal. Bebchuk would argue that the law should figure out ways to encourage undistorted shareholder choice on matters of changes to corporate control. By contrast, McConvill argues that both Bainbridges director primary and Bebchuks shareholder primacy arguments miss the point that shareholder participation should be an end in itself. There is a trend in the DE court in the direction of empowering shareholders which might not make sense given that S/Hs have differing time horizons and different appreciations of risk.

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Given that the Unocal line of cases tend to respect a target BoDs blocking power in tender offers aimied at target S/Hs as long as they take reasonable and proportional defenses against a legitimate threat to corporate policy, hostile purchasers have increased their use of proxy fights to solicit approval directly from shareholders. In these cases, a hostile bidder makes a tender offer conditioned on winning a proxy fight for control of the target board. Once the hostile bidder gets control of the board, they can redeem any outstanding poison pills and remove any other anti-takeover devices. While DE courts are somewhat tolerant of takeover defenses in tender offers under the Unocal line, a new line of cases suggest that the corut is less tolerant of these defenses if they infringe on the shareholders right to vote. Under Blasius, the court held that even BoD actions taken in good faith would constitute a breach of loyalty if done for the primary purpose of interfering with a S/H vote. While the court rejected adopting a per se rule, It argued that a BoD whose acts are primarily done for the purpose of impeding shareholder voting power have a heavy burden of demonstrating a compelling justification for the action. In Blasius, a 9% shareholder sent a consent agreement that, if approved by the shareholders, would have expanded the BoD from 7 to 15 and granted the S/H the right to elect 8 new members thus gaining control of the board. The Atlas BoD responded to a consent agreement by increasing the board from 7 to 9 members so that even if the consent agreement was ratified by the S/Hs, it could not be implemented. The court held that this action, even made in good faith, constituted a breach of the duty of loyalty. It is difficult to know, under Blasius, how directors could ever meet the burden of proof for a compelling justification and when this new standard should be applied. Practical Effect: Does Unocal or Blasius Apply? Hard to Tell. The practical impact of Blasius is that if the court invokes the Blasius standard of review the board action under examination will likely be invalidated. However, if the court invokes the Unocal standard of review, the board action will frequently survive the review. In Aquila, Inc. v. Quanta Services, Inc. the court refused to apply the Blasius compelling justification test in assessing whether Quanta BoDs adoption of a Stock Employment Compensation Trust (SECT) that would dilute shareholders voting power and increase the likelihood of Quantas management winning a proxy contest. It argued that the SECT simply makes it more difficult, but not impossible for Aquila to win the proxy contest (as opposed to Blasius where the BoD essentially prevented the S/Hs from being able to grant Blasius the ability to gain control of the BoD). Therefore, in Aquila the court assessed the SECT and the voting restrictions under a Unocal standard. Arguing that the Unocal standard was met, the court applied the BJR to the SECT and held it would not substitute its judgment for that of the BoD. Aquila leaves open the question of how much dilution of the hostile partys voting power is necessary in order to trigger a Blasius compelling justification standard of review. In Chesapeake v. Shore, the court also struggled with whether the Unocal or Blasius standard of review was appropriate in examining the validity of a Supermajority Bylaw adopted by the BoD. Chesapeake argued that the primary purpose in adopting the Supermajority bylaw was to interfere or impede the exercise of S/H franchise and therefore theat the Blasius compelling justification standard was appropriate. The directors argue that the bylaw did not preclude S/Hs from amending the bylaws and was adopted as a defensive measure against a hostile takeover and therefore that a Unocal standard was appropriate. The court held that Unocal was appropriate because of the defensive origin of the adoption of the Supermajority bylaw. After performing a Unocal analysis, the court held that Blasius applies because the BoDs primary purpose in adopting the Supermajority Bylaw was to reduce voting power of Chesapeake to impair its ability to win the Consent Solicitation to preclusive levels. The BoD clearly acted to interfere with or impedethe exercise of the shareholder franchise. Therefore, the compelling justification standard applies. Moreover, the court in Paramount v. Time, did not even address the issue of S/H disenfranchisement. In Time, the BoD restructured the deal with Warner from a stock-to-stock exchange into a cash tender offer that did not require a S/H vote. The court did not address whether the BoD decision to restructure the merger, thereby impeding the shareholders ability to vote violated their fiduciary duties. Rather, the court simply upheld the Time BoDs refusal to entertain Paramounts bid and held that all Times defensive measures met the Unocal standard of review.

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