Two recent decisions from the Court of Chancery — In re Orchid Cellmark Inc. Shareholders Litigation and In re Answers Corp. Shareholders Litigation — illustrate how parties may reduce deal risk by ensuring that the directors responsible for managing a sale process are disinterested and independent. At the same time, while the court in both cases rejected challenges to the transactions based on allegedly excessive deal protection terms, the court also signaled that providing much more than the parties did in Orchid may break the court’s proverbial back.
Independence and Disinterest
The court decided each of these cases following an expedited preliminary injunction hearing at which the plaintiffs sought to enjoin the transactions based in part on an allegedly inadequate sales process. In this Revlon Inc. v. MacAndrews & Forbes Holdings Inc. context, the court is called upon "to assess carefully the adequacy of the sales process employed by a board of directors." A primary inquiry in assessing a transaction is whether the directors responsible for the negotiations are independent and disinterested.
In Orchid, the court noted that five out of the six directors were independent. Its board formed a special committee to negotiate the transaction. That committee included two independent directors and a third newly elected director who had been nominated by the company’s largest shareholder. In addition to the independence of the special committee, the court also found no reason to doubt the independence or credentials of the special committee’s financial adviser.
Likewise, in Answers, although the plaintiffs raised questions about the independence of two of the directors, the court found that those directors did not lead the negotiations. Moreover, four out of the seven directors who approved the transaction were disinterested and independent. Finally, the court held that the company’s financial adviser’s independence and qualifications were not seriously challenged. The independence of the directors and their advisers were significant factors in the court’s decision in both cases to uphold the reasonableness of the boards’ decision making.
Deal Protection Terms
The court noted that deal protection terms such as termination fees, expense reimbursements, and no-talk and no solicitation clauses are standard. The issue is whether cumulatively they are impermissibly coercive or preclusive of alternative transactions. In Answers, the court observed that the break-up fee of 4.4 percent of equity value was at the upper end of the "conventionally accepted" range.
However, the court stated that this is not atypical in a smaller transaction. The court also rejected the plaintiffs’ challenge that the court should measure the break-up fee in reference to enterprise value on the ground that "Our law has evolved by relating the break-up fee to equity value."
In Orchid, the parties' deal protection included not only standard no-shop and termination provisions, but also a top-up option, matching rights and an agreement to pull the company’s poison pill, but only as to the buyer. The court held that top-up options are standard in two-step tender offer deals. As to the termination fee, the court found it appropriate in reference to the equity value of the target and again rejected the plaintiffs' effort to measure the termination fee in reference to enterprise value. The court also recognized that the matching and informational rights might have a deterrent effect on a hypothetical bidder, but it found those provided in the merger documents would not preclude a serious bidder from stepping forward.
The court also found that the selective pulling of the pill was not impermissibly preclusive of alternative bids. The court reasoned that the merger agreement enables the board to redeem the pill if it terminates the merger agreement. Termination is permitted if the board receives a superior offer and withdraws its recommendation that the stockholders tender their shares. The court observed that the termination fee that would be owed if the board terminates the merger agreement for a bidder who makes a superior offer and then pulls the pill would be no greater than if the company accepts a superior offer or terminates the merger agreement for some other reason.
Finally, because "a sophisticated and serious bidder would understand that the board would likely eventually be required by Delaware law to pull the pill in response to a Superior Offer," the court ruled that the deterrent effect of these provisions likely was minimal.
In so holding, the court stated that deal protection measures evolve and cautioned that at some point incremental protection may prove too much:
"Deal protection measures evolve. Not surprisingly, we do not have a bright line test to help us all understand when too much is recognized as too much. Moreover, it is not merely a matter of measuring one deal protection device; one must address the sum of all devices. Because of that, one of these days some judge is going to say 'no more' and when the drafting lawyer looks back, she will be challenged to figure out how or why the incremental change mattered. It will be yet another instance of the straw and the poor camel's back. At some point, aggressive deal protection devices — amalgamated as they are — run the risk of being deemed so burdensome and costly as to render the 'fiduciary out' illusory."
Together, these two cases demonstrate the value of a disinterested and independent decision-making body running a sale process. Also, while the court rejected claims that the deal protection at issue was preclusive or coercive, the court also cautioned that counsel must be careful not to make an alternative transaction too burdensome or costly, lest any fiduciary out be deemed illusory. Counsel should carefully evaluate the context of each transaction in determining appropriate deal protection, lest an added straw of protection is found to be the one that breaks the court’s proverbial back.
Lewis H. Lazarus ( firstname.lastname@example.org) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm's clients.