Page 1 Fried Frank Inside Delaware Supreme Court Affirms SynQor—Where Things Now Stand in Permitting Early Dismissal of Fiduciary Duty Claims in Controller Transactions Under MFW Page 4 Delaware Supreme Court Affirms Rural Metro—But Rejects Concept of Investment Bankers as “Gatekeepers,” Narrowing Potential Liability for Bankers in M&A Transactions Page 9 Change in SEC’s Longstanding Approach to Exclusion of “Conflicting” Shareholder Proxy Proposals Creates Uncertainty Page 12 Practice Points Relating to Adjustment of the Merger Price in Appraisal Cases—the Effect of BMC Software Page 14 For Buyers and Sellers of Portfolio Companies, Practice Points Arising from Chancery Court’s Prairie Capital Decision Page 17 Authors Abigail Pickering Bomba Aviva F. Diamant Steven Epstein Arthur Fleischer, Jr. Peter S. Golden Brian T. Mangino Philip Richter Robert C. Schwenkel Peter L. Simmons Gail Weinstein M&A QUARTERLY A quarterly roundup of key M&A developments 4th Quarter 2015 Fried Frank M&A Quarterly Copyright © 2016. Fried, Frank, Harris, Shriver & Jacobson LLP. All rights reserved. Attorney Advertising. Valeant’s Recent Stock Price Collapse (continues on next page) Historically, in the context of acquisition bids in which a substantial component of the proposed consideration is the bidder’s equity, target companies frequently have made generalized assertions that a hostile bidder’s equity is overvalued. However, there have been relatively few aggressive, focused, detailed, public challenges by targets to the value of a bidder’s equity. In the aftermath of the failed 2014 Valeant Pharmaceuticals International Inc. hostile bid for Allergan Inc., the collapse of Valeant’s stock price in 2015 underscores that, in seeking to protect its stockholders in the context of a hostile (or a friendly) bid, targets should consider taking more aggressive action than has been typical in the past to investigate specific, fundamental and material concerns about the bidder’s equity. If a bidder approaches the target confidentially at first about a possible hostile bid, and if the target has these concerns and commences the investigation, it may also serve to forewarn the bidder as to what an actual public bid for the company would entail. Key Points Targets should consider a more aggressive investigation of a bidder’s equity value than has been typical in the past. While target companies typically have evaluated the equity their stockholders would receive in a proposed transaction, targets should more aggressively investigate when there is a basis for specific, fundamental and material concerns about the bidder’s business, finances or accounting. (See “Practice Points” below for specific steps a target should consider taking.) Importantly, before embarking on an aggressive, public campaign challenging the bidder’s equity, a target company should seek to ensure that there is likely a Valeant’s Recent Stock Price Collapse Underscores Importance of Considering Aggressive Action to Evaluate a Bidder’s Equity—Lessons for Targets, Co‑investors and Bidders Page 2 Valeant’s Recent Stock Price Collapse (continued from previous page) Valeant’s Recent Stock Price Collapse (continues on next page) strong basis for proceeding, as there could be significant downside to mounting a public challenge if it turns out to have been unsupportable. In the context of a hostile bid, if the target’s concerns are substantiated, the target company should communicate them to its stockholders. An effective communication plan should be developed, with a clear, understandable, consistent “message” that is repeated at every opportunity. Bidders themselves, and any co-investors, have a similar interest in a thorough investigation of the bidder’s equity value. An acquiror stock price collapse during a takeover campaign would almost certainly have materially adverse consequences for a bidder and any co-investor supporting the bid. The bidder, prior to making a proposal, would want to ensure that its equity will withstand scrutiny and that responses to any questions that may be raised by the target have already been formulated. An equity investor who is a joint bidder or is otherwise supporting a bid has a similar interest in evaluating and investigating any concerns relating to the bidder’s equity, which would affect both the value of any equity it would acquire in the target and/or the bidder and its confidence level with respect to the credibility of the proposed deal. Background—Valeant-Allergan takeover battle and the recent Valeant stock price collapse During Allergan’s seven-month defense last year against Valeant’s hostile all-stock takeover bid, the keystone of Allergan’s defense was an attack on the long-term value of Valeant’s equity. Allergan had argued that Valeant’s business model was unsustainable (with serial acquisitions, followed by slashing of the acquired companies’ research and development budgets); that Valeant’s financial reports were opaque and inadequate (with one-time charges associated with the serial acquisitions resulting in numbers that were misleading and difficult to evaluate); and that Valeant’s management was not competent. Those concerns, effectively communicated to the Allergan stockholders, convinced the stockholders to give the Allergan board the time it needed to consider the transaction, to negotiate with Valeant, and to seek alternatives—notwithstanding considerable pressure on the Allergan stockholders by Valeant (and co-investor William Ackman’s activist hedge fund Pershing Square) to support the Valeant bid. In November 2014, Allergan agreed to a merger with white knight acquiror Actavis plc, at a higher price, at which point Valeant’s bid was withdrawn. Now, about a year later, following the November 2015 issuance of an investment research firm’s report detailing how Valeant generates its drug sales numbers, the Valeant stock price dropped almost 30% in a single day—about 50% for the month, and about 70% from the stock’s high in August 2015. The report revealed that Valeant has an unusual business relationship with, and unusual accounting practices with respect to its sales to, a number of small regional pharmacies. The report—entitled “Could [Valeant] be the Pharmaceutical Enron?”)—alleges that Valeant has been engaging in a series of sham transactions with the pharmacies (storing inventory with them but characterizing the transactions as sales) in order to inflate its sales numbers. If Valeant was engaging in these practices at the time of the takeover bid, and if Allergan had discovered this, the outcome that Allergan ultimately achieved likely would have been quicker and, possibly, even better for Allergan—with Valeant’s stock price collapse occurring earlier, Allergan likely remaining independent, and hedge fund Pershing Square (which was supporting the Valeant bid) suffering a significant loss on both its toehold investment in Allergan and its separate investment in Valeant. Practice Points Steps a target should consider taking to evaluate a bidder’s equity. In an effort to protect target stockholders’ interests in a deal in which the bidder is proposing to issue its equity for all or a major portion of the consideration, a target company should consider the following: With the target’s financial advisor (and any other appropriate advisors), conduct a thorough review of the bidder’s business, prospects, equity trading prices, and all other relevant information. While this has been Page 3 Valeant’s Recent Stock Price Collapse (continues on next page) Valeant’s Recent Stock Price Collapse (continued from previous page) the usual course for target companies, there should be renewed focus on an even more thorough effort when circumstances indicate that it is warranted. Characteristics of a bidder that should trigger particular scrutiny would include a very aggressive acquisition history; very aggressive and/or opaque accounting; an unusual or short-term oriented business model; the absence of a substantial track record; significant recent business or structural changes (including a restructuring); unusually large or frequent special changes; significant regulatory or litigation issues; stock that trades at an unexpectedly high multiple (and so is potentially more vulnerable); very high leverage; market or investor focus on the non-GAAP numbers; and issues about management reputation or experience. If appropriate, engage accountants to do an in-depth forensic accounting review of the bidder. If the bidder and target are in discussions, the target should seek to obtain appropriate access to the bidder’s management and accountants for purposes of evaluating the bidder’s equity. Compare the bidder’s GAAP and pro forma or other non-GAAP financial reporting, and consider to what extent the market has relied on the latter and whether the reliance was appropriate. Consider the bidder’s outstanding and historical regulatory and litigation issues. Consider the bidder’s business model with a view to whether it is sustainable over the long-term. Consider the bidder management’s and board’s experience and reputation. Consider analysts reports, blogs, employee forums, and other sources of commentary—and focus on any hints of impropriety or weaknesses in the bidder’s practices, policies, business model, or otherwise, that could affect the bidder’s equity. Consider seeking to engage in discussions with analysts of or investors in the bidder; the bidder’s largest customers or suppliers; former executives of the bidder; other companies that have engaged in transactions with the bidder and received its equity; and other possible sources of information. If appropriate, consider seeking SEC, Congressional or other regulatory investigations into the bidder’s business practices, compliance, or other matters. If appropriate, consider buying the bidder’s stock and filing a books and records request in court (if permissible under state law) to obtain as much information as possible. Steps a target should consider taking to protect the equity value to be received in a deal. If a target agrees to receive equity consideration in a deal, the target should take steps to seek to protect the value of the equity to be received at closing, including: Consider a combination of caps, floors and/or collars on the number of shares to be issued at closing in order to ensure that the number remains in a range that will be acceptable to both the acquiror and the target. In addition, or alternatively, consider utilizing a convertible preferred stock for part of the consideration or a value assurance plan. Consider negotiating for a continuing due diligence right and a due diligence termination right—i.e., the right to continue to conduct specified (or general) due diligence after signing, as well as a right to terminate the agreement if specific (or general material) information is discovered before closing, together with a breakup fee if triggered. Consider providing for a post-closing value assurance plan that would adjust the equity issued or otherwise compensate target stockholders. Page 4 Steps a bidder should consider taking if it intends to issue its equity in a deal. If a bidder intends to propose to issue its equity for all or a major portion of the consideration in a deal, before making the bid, the bidder should, to the extent possible, anticipate, and remedy or prepare responses for, questions or concerns that may arise about the bidder’s financial results and reports, business model, prospects, management, investors, compliance, disclosure, and so on. A bidder should have a plan ready so that it can quickly and effectively communicate easily understood and compelling responses to issues that may arise. The bidder’s accountants and investment bankers should work with the bidder to anticipate areas of potential concern and to develop appropriate responses. Steps a co-investor should consider taking if the bidder intends to issue its equity in a deal. A co-investor, or other type of supporter of a bid, will be exposed to the potential for significant losses if serious issues arise with respect to the bidder’s equity. If the issues arise early in the process, the bid may become illusory or withdrawn, in which case the co-investor will be at risk both on the toehold investment made in the target and in any investment in the bidder. If the deal is effected, the co-investor will be at risk on its investment in the bidder through its obtaining the bidder’s equity in the deal. Further, the co-investor may face reputational risk if it has made a large investment and has been publicly identified with the bid. (We note that, in the Valeant-Allergan situation, the co‑investor (Pershing Square) stood to—and ultimately did—achieve such a large return on its toehold investment in the target that it overshadowed the losses on its separate investment in Valeant; however, as we have discussed in previous memoranda, the Pershing Square co-investment model was not likely to be—and, indeed, has not been—followed by others for a variety of reasons.) Valeant’s Recent Stock Price Collapse (continued from previous page) Delaware Supreme Court Affirms SynQor—Where Things Now Stand in Permitting Early Dismissal of Fiduciary Duty Claims in Controller Transactions Under MFW In a much anticipated ruling, the Delaware Supreme Court has affirmed—without an opinion— the Court of Chancery’s August 2014 oral ruling from the bench in Swomley v. Schecht (usually referred to as “SynQor”). The Chancery Court’s SynQor ruling represented the first application of the Delaware Supreme Court’s landmark MFW decision. MFW provided a pathway to business judgment review (rather than the more stringent entire fairness review) of controller transactions if six prerequisites (described below) were satisfied. In the view of some commentators, the MFW opinion suggested a higher bar to dismissal at the pleading stage of stockholders’ breach of fiduciary duty claims against directors in controller transactions than was applied in SynQor. This view was based on commentary in MFW to the effect that questions about the fairness of a transaction price inherently would raise questions about the special committee’s having fulfilled its duty of care. The Supreme Court’s affirmance of SynQor indicates, however, that, if the MFW prerequisites have been met, a special committee’s duty of care will be measured under a gross negligence standard. Thus, MFW should not be interpreted as setting a high bar to pleading-stage dismissal of fiduciary duty claims in controller transactions—unless the pleadings provide a foundation for inferring gross negligence by the special committee (or other failures to meet the MFW prerequisites to business judgment review of the transaction). As articulated by Vice Chancellor Laster in the Chancery Court SynQor decision, the six MFW prerequisites are: (i) the deal being conditioned, from the outset, on the approval both a special committee and a majority-of-the-minority vote of the disinterested stockholders; (ii) the special committee being independent; (iii) the special committee being empowered to freely select its own advisors and to say no definitively; (iv) the special committee meeting its duty of care in negotiating Delaware Supreme Court Affirms SynQor (continues on next page) Page 5 Delaware Supreme Court Affirms SynQor (continued from previous page) the price (which, the Vice Chancellor emphasized, “is measured by a gross negligence standard… [that] is only satisfied by conduct that really [constitutes] recklessness… [or possibly even] wanton conduct”—making it “a very tough standard to satisfy.”); (v) the vote of the disinterested stockholders being informed (i.e., adequate disclosure to the minority stockholders); and (vi) the minority stockholders not being coerced (through “retributive threats”). Impact of the SynQor affirmance Will lead to early dismissal of fiduciary duty litigation challenging controller transactions that meet the MFW requirements. The affirmance of SynQor appears to indicate that, in controller transactions in which the MFW requirements have been satisfied, whether involving a public or a private company, business judgment review (which is highly deferential to the decisions of directors) will be applied. Thus, unless the pleadings provide a foundation for inferring gross negligence by the special committee (or that the MFW requirements otherwise have not been met), there will not be a high bar to dismissal of complaints relating to the directors’ actions at the pleading stage. Controllers generally will be advantaged by causing their proposed transactions to meet the MFW requirements. A controller generally will be advantaged by causing its proposed transaction to comply with the MFW prerequisites so that the controller will be in a position to obtain business judgment review of, and, thus, early dismissal of fiduciary duty litigation relating to, the transaction. However, as discussed below, there may be circumstances where the controller would choose to forego the potential for early dismissal rather than to include the MFW-prescribed majority-of-the-minority stockholder vote condition. Courts’ guiding principle is that most fiduciary duty litigation is premised on a disagreement about valuation, not fiduciary duties. Vice Chancellor Laster had emphasized the “promise” of MFW that “there would be a way to distinguish between cases that actually raised breach of fiduciary duty claims and those cases that only challenged judgmental factors of valuation.” The Vice Chancellor had explained that, when the MFW prerequisites have been met, stockholders’ claims necessarily reflect a disagreement on valuation rather than breach of fiduciary duties—and that, to fulfill the promise of MFW, those claims should “be channeled to appraisal.” Fewer fiduciary duty cases, and more appraisal cases, may be brought with respect to controller transactions. The SynQor affirmance is consistent with the courts’ general efforts toward, as often as possible, evaluating directors’ actions under the business judgment rule and dismissing fiduciary duty litigation at the pleading stage—thereby discouraging the bringing of fiduciary duty litigation generally. It is possible that, as a result, fewer fiduciary duty cases in controller transactions, and more appraisal cases, may be brought. While appraisal cases involve a number of risks for dissenting stockholders, we note that the Chancery Court continues to determine appraised “fair value” to be above the merger price in cases involving controllers (often, well above the merger price, when the sale process has been regarded by the court as inadequate)—although the court has been moving toward increased reliance on the merger price to determine fair value in non-controller transactions where the sale process has included active shopping of the target company. Supreme Court’s MFW Ruling Uncertainty after MFW: Issue as to the standard the pleadings need to meet to support dismissal at the pleading stage—the MFW pleadings would not support early dismissal, according to the Supreme Court. In MFW, the Supreme Court stated that stockholders’ claims challenging a going private merger with a controller would not be dismissed, and would proceed to the discovery stage, if at the pleadings stage the stockholders had raised “any reasonably conceivable set of facts” indicating that the process or disclosures relating to the transaction were deficient. The stockholders’ pleadings in MFW appeared to be little more than allegations that the price was too low—because the ratio to profits per share and pre-tax cash flow were below those of other recent transactions; the price was below the price the stock had traded at just two months earlier; the stock price was depressed because of short-term factors, such as MFW’s acquisitions and S&P’s downgrading of U.S. debt; and commentators had viewed the price as Delaware Supreme Court Affirms SynQor (continues on next page) Page 6 low. Moreover, the Supreme Court found that the board process, the financial advisor process, and the disclosure in MFW were beyond reproach (and that the price was within the range of fairness as determined by the financial advisor). Nonetheless, the Supreme Court (in a now-famous footnote in the decision) stated that, if the procedural requirements established in the case had been satisfied, these claims would not have supported dismissal at the pleading stage. The Court observed that “allegations about the sufficiency of price call into question the adequacy of the Special Committee’s negotiations.” In other words, the Supreme Court appeared to indicate that questions about price inherently raise questions about process—and that, notwithstanding the pathway to business judgment review established by MFW, there would still be a high bar to the dismissal of fiduciary duty claims at the pleading stage. As price-related allegations such as those made in MFW can be made in many (or even most) stockholder suits, the question arose after MFW whether, under the pleading standard as enunciated in MFW, few fiduciary duty suits involving controller transactions would be likely to be dismissed at the pleading stage. Chancery Court’s SynQor Decision—first test of the application of MFW Background. Under the merger agreement between SynQor and its controlling stockholder, the minority stockholders would receive $1.35 per share in cash in the merger. The merger was structured with the intention of complying with the MFW roadmap for business judgment review of controller transactions. The merger was conditioned on the approval of a special committee and of a majority of the minority stockholders not affiliated with the controller. The special committee (comprised of two independent directors) was empowered to retain its own advisors and to “say no” to the transaction. The committee ultimately negotiated a $0.25 per share increase in the price and approved the merger, which was then approved by 61% of the unaffiliated minority stockholders. Issue as to consistency with MFW—Chancery Court holds that the SynQor pleadings do support early dismissal. In the first test of the application of MFW, Vice Chancellor Laster, in SynQor, granted the defendants’ motion to dismiss, at the pleading stage, the stockholders’ challenge to a cash-out merger of SynQor (a private company) with its controlling stockholder. In what some commentators considered to be a significant departure from MFW, the Vice Chancellor dismissed the case even though the plaintiffs had alleged facts that raised what appeared to be non-trivial issues relating to price, disclosure and process. The issues raised appeared to be at least as compelling as the allegations made in MFW (which, as noted, the Supreme Court had stated would not have resulted in dismissal of MFW at the pleading stage). The SynQor pleadings. The SynQor plaintiffs alleged substantive flaws in the bankers’ work, the sale process, and the disclosures, including allegations directly relating to the special committee’s valuation of the company—such as its relying on non-traditional methodologies in valuing the company’s patent portfolio; not having insisted on some type of contingent payment relating to litigation the company was involved in; and having “lump[ed] on [a] 20 percent discount” to the company’s valuation. Without characterizing how the pleadings compared to those in MFW, Vice Chancellor Laster dismissed the case at the pleading stage, emphasizing that, in his view, MFW intended and required that result. The MFW ruling, he said, represents a “promise,” and the prescribed standard was “born with the goal,” that parties in controller transactions could effectively structure a transaction so that they could obtain a pleading-stage dismissal against breach of fiduciary duty claims.” More uncertainty after SynQor. Beyond the question of the appropriate standard for the pleadings to obtain early dismissal, the decision intensified the general uncertainty as to both the rationale and the application of MFW. For example, the SynQor decision: Highlighted the paradox created by MFW of a low standard of review in controller transactions. The SynQor decision highlighted a basic paradox inherent in MFW—that the lowest standard of review for directors’ actions will apply in controller transactions (even those involving a close corporation), which one might expect would be the type of transaction requiring the greatest level of protection for stockholders. Delaware Supreme Court Affirms SynQor (continues on next page) Delaware Supreme Court Affirms SynQor (continued from previous page) Page 7 Ignored the private company context in SynQor as compared to the public company context in MFW. The court had reason in SynQor to be more, rather than less, skeptical of the process than in MFW, as SynQor involved a private company (with only two outside directors and no history of providing information to or meeting with stockholders), while MFW was a public company. While Vice Chancellor Laster acknowledged that the private company context “could be a factor” in applying MFW, the decision largely ignored the issue. Disregarded the lack of discovery in SynQor as compared to the extensive discovery in MFW. The MFW plaintiffs had had the opportunity to conduct discovery for eighteen months (including a review of over 100,000 pages of documents, as well as depositions of all four special committee members and the financial advisors and senior executives of both companies)—a fact specifically noted by the Supreme Court when it affirmed the Chancery Court’s MFW decision. The extensive discovery thus was available in MFW—and no such record was available in SynQor—to inform the court’s decision as to whether the transaction met the MFW conditions. The Vice Chancellor’s expression of his own uncertainty. Reflecting this general uncertainty, after stating his ruling in SynQor, Vice Chancellor Laster told the parties: “It is certainly possible that I have erred [in interpreting MFW and the related cases]… [a]nd I am not offended at all if [plaintiffs appeal and] turn out to establish that.” Plaintiffs’ counsel’s commented in response that the plaintiffs would appeal, adding: “[W]e’re all going to learn.” Delaware Supreme Court’s Affirmance of SynQor Affirmance without an opinion. Notwithstanding these concerns and Vice Chancellor Laster’s expression of his own uncertainty about whether he properly applied MFW in SynQor, the Delaware Supreme Court, without an opinion, ruled that the “final judgment of the Court of Chancery [in SynQor] should be affirmed for the reasons stated in [the Court of Chancery’s] bench ruling.” Without an opinion elucidating the Supreme Court’s reasoning, the meaning and impact of SynQor to some extent remain uncertain pending further judicial development. Post- SynQor Practice Points—Where things now stand Process continues to be important. As a practical matter, a truly independent, well-functioning, engaged and informed special committee; a majority-of-the-minority vote condition; a thorough investment banking process; and appropriate disclosure of material information will always be an advantage if a transaction is challenged. Independence of special committee directors. If directors are to be paid to serve on a special committee, the payments should be established at the outset of the process and should not be contingent in any way on the controller’s proposed transaction being effected. SynQor indicates that longstanding directors’ historical involvement with a private company, and payment for directors’ service on a special committee (at least when arranged at the outset and not contingent on the proposed transaction), do not, without more, impeach the independence of directors serving on a special committee. We note that the court did not consider whether there are any special considerations relating to directors’ independence that may arise in the private company context (for example, a heightened burden such as no financial dependency; a consideration of any other directorial experience on the part of the individual; and/or an evaluation of the personal relationships between the controller and the director). Proxy statement disclosure in private company transactions. The court was positively influenced by the company’s use of a “public-company-style proxy statement” in connection with the stockholder vote on the transaction (and did not address the difference in a private company context that the discipline of an SEC staff review of the proxy statement is lacking). The decision also suggests that at least some types of flaws in a sale process may be significantly ameliorated (if not negated) by their being adequately disclosed to stockholders. For example, the court stated that the plaintiffs had “really raise[d] some real questions” about the work of the target company’s investment bankers, but concluded that the proxy statement provided “a fair summary of that work, even assuming that there Delaware Supreme Court Affirms SynQor (continues on next page) Delaware Supreme Court Affirms SynQor (continued from previous page) Page 8 were some questionable decisions made.” Clearly, if the banker’s work raises questions, those questions should be addressed by the management and the board. Coercion by the controller. According to the decision, a controller’s “threat” that the status quo would be maintained if the controller’s transaction were not approved by the minority stockholders (in SynQor, that a no-dividend policy would be continued and that management would not change) does not constitute impermissible coercion, even if (as in SynQor) the status quo is not viewed as favorable by the minority stockholders. Conversely, one test of coercion is whether there has been a threat that the status quo would not be maintained if the deal were voted down. Price negotiations. As has been typical, the increases in the deal price achieved through the special committee’s negotiations (from an initial offer of $1.10 per share to a deal price of $1.35) appeared to be the primary factor in the court’s evaluation of the special committee’s effectiveness. Plaintiffs’ pleadings. Plaintiffs’ pleadings will most likely be given less credibility if in the nature of a generalized complaint that the price was not as high as the plaintiffs would have liked or as possibly could have been obtained by a harder working or better special committee. The more specific the allegations as to failures to meet the MFW tests or as to the non-exculpable conduct of the target directors, the more likely that the complaint will not be dismissed at the pleading stage. Majority-of-the-minority vote condition. To obtain MFW treatment, the controller should, from the outset, be clear that its proposal is subject to a majority-of-the-minority vote condition. There continues to be some uncertainty as to what “the outset” of the process is. In SynQor, the court found that the condition had been in place from the outset because “from the first meeting” the board had resolved that any deal with the controller would be subject to the condition. The court noted that the controller’s initial proposal had “hedged” as to whether the deal would include the vote condition, but concluded that the hedging was not a problem because “the controller, or the lead guy [(i.e., the CEO)], was part of the board that made the determination [about the condition].” The court did not address that MFW requires that the controller must insist on the condition and did not explain how it was relevant that the controller was on the board that made the decision to impose the condition (when the controller himself was “hedging” about the condition and, presumably, would not have been part of the board discussions about his proposed transaction). Controller’s decision whether to use the MFW-prescribed structure. Even before MFW, virtually every controller transaction was structured to be conditioned on approval of a special committee of the board; however, a minority stockholder vote condition was less common. Given the SynQor affirmance, a controller generally will be advantaged by including the majority-of-the-minority vote condition so that it will be in a position to obtain early dismissal of fiduciary duty litigation. There may be circumstances, however, where the controller would choose not to include the condition—based on considerations such as the likelihood of obtaining minority stockholder approval for the transaction; the possibility of activist intervention, with minority holders seeking to disrupt the process; and the balance between the cost in terms of a higher price that may have to be paid in a process that includes the MFW procedural protections for the minority stockholders (and so will be reviewed under the business judgment standard) as compared to the cost that may arise in shareholder litigation arising out of a process that does not include the protections (and will be reviewed under entire fairness). Court’s movement toward “unified business judgment review.” As articulated recently by former justice of the Delaware Supreme Court Jack B. Jacobs, SynQor appears to be another component of the broad trend by the Delaware courts to reduce the volume of litigation challenging M&A transactions generally, including by providing roadmaps for business judgment review of transactions, thus enabling defendants to obtain early dismissal of lawsuits challenging a transaction. Jacobs has written: “That initiative benefits not only the transacting parties, but also the Delaware court system whose resources, like those of all courts, are necessarily finite and must be prioritized in favor of disputes that present genuine claims meriting relief.” Delaware Supreme Court Affirms SynQor (continued from previous page) Page 9 In an important decision, RBC Capital Markets, LLC v. Jervis (commonly referred to as “Rural Metro”) (Nov. 30, 2015), the Delaware Supreme Court affirmed the Chancery Court’s holding that the investment bank to target company Rural Metro had aiding and abetting liability for breaches by Rural Metro’s directors of their fiduciary duties in connection with the sale of the company to a private equity firm at a price that the Chancery Court found to be inadequate and the result of a flawed process. Importantly, however, the Supreme Court: characterized its ruling as “narrow”; indicated that the “unusual” facts of the case led to the result; and expressly rejected the Chancery Court’s description of target company investment bankers generally as having a “gatekeeper” role in the sale process. The Chancery Court’s decision in Rural Metro—which followed a period of unusual focus by the Chancery Court on investment banks’ actual and apparent conflicts of interest in target sale engagements—represented the first time that the court had found a banker liable for aiding and abetting directors’ breaches of fiduciary duty in an M&A transaction. The decision raised significant concerns that bankers would be subject to different standards than in the past and would be much more vulnerable to aiding and abetting claims and liability. While affirming the finding of aiding and abetting liability in this case, the Supreme Court’s opinion indicates that, contrary to the concerns that arose after the Chancery Court opinion: Financial advisors likely will be held to be liable for aiding and abetting directors’ breaches of fiduciary duty in a sale process only in a narrow set of cases, where the advisor’s conduct is regarded by the court as especially egregious and involves scienter; and Financial advisors will not be regarded by the courts as “gatekeepers” of a company’s sale process, and so will not be viewed as having any affirmative obligation to prevent directors from breaching their duty of care in a sale process. Background Following the announcement by Rural Metro that it had agreed to be sold to an affiliate of a private equity firm, Rural Metro stockholders brought litigation claiming (i) breaches by the directors of their fiduciary duties in connection with the sale and (ii) aiding and abetting liability for the company’s two financial advisors. The directors (who in any event would have been exculpated by any breaches of the duty of care) and one of the two financial advisors settled before trial, leaving just one financial advisor to face trial. The Chancery Court’s March and October 2014 decisions found the financial advisor liable for $91.3 million in damages (including interest). The Chancery Court found, in essence, that the directors had breached their fiduciary duty of care by having failed to effectively supervise the financial advisor’s conduct. Moreover, the financial advisor, through its bad conduct, had “knowingly participated” in the board’s oversight failure, according to the court. The Chancery Court found that the advisor had crafted the sale process to further its own interests, trying to leverage its sell-side role for Rural Metro to obtain buyside roles with companies bidding for a competitor company (EMS) and to provide staple financing to the buyer of Rural Delaware Supreme Court Affirms Rural Metro (continues on next page) Delaware Supreme Court Affirms Rural Metro— But Rejects Concept of Investment Bankers as “Gatekeepers,” Narrowing Potential Liability for Bankers in M&A Transactions Page 10 Delaware Supreme Court Affirms Rural Metro (continued from previous page) Delaware Supreme Court Affirms Rural Metro (continues on next page) Metro. According to the court, during price negotiations with the only party to ultimately submit a bid for Rural Metro, the advisor solicited that party for a role in providing the buy-side financing, without disclosing these efforts to the Rural Metro board; and, although the buyer declined the financing offer, the advisor’s solicitations had affected Rural Metro’s negotiating position over the final sale price. Further, the Chancery Court found that the financial advisor had created an “informational vacuum” for the board, with the materials that were prepared for the board being inadequate and not being timely provided. Key Points Court rejects potential liability for target financial advisors based on a “gatekeeper” role. Although the Supreme Court upheld the Chancery Court decision, the Supreme Court expressly “disavowed” the Chancery Court’s characterization of financial advisors as having a “gatekeeper” role in connection with a sale process. In the Chancery Court opinion, Vice Chancellor Laster stated that target company financial advisors faced potential aiding and abetting liability based on their role as “gatekeepers” of the sale process, given their special position in terms of the target company board’s trust in and reliance on them. The Vice Chancellor’s broad language and reasoning gave rise to concerns that the court regarded bankers as having a responsibility to ensure a board’s compliance with its fiduciary duties—suggesting that any failure by a banker to prevent directors from breaching their fiduciary duties would give rise to aiding and abetting liability of the banker. The Supreme Court, rejecting application of a gatekeeper role for financial advisors, emphasized the primarily contractual nature of the relationship between a board and its banker; that the terms of that relationship are typically negotiated by sophisticated parties on both sides; and that “it is for the board… to determine what services, and on what terms, it will hire a financial advisor….” Aiding and abetting liability for bankers can be expected to be limited to cases involving egregious conduct by bankers. The Supreme Court affirmed the Chancery Court’s conclusions that the financial advisor had “intentionally duped” the Rural Metro board “for [the advisor’s] own motives” and had “purposefully misled the Board so as to proximately cause the Board to breach its duty of care.” The Supreme Court characterized the facts of the case as “unusual” and its ruling as “a narrow one.” Although the Supreme Court noted that the appellants had expressed that their claims on appeal were framed to avoid the Court having to review the lower court’s findings of fact, the Court stated that it had nonetheless fully reviewed the factual record. Indeed, half of the 108 pages of the opinion were devoted to a re-recitation of the facts of the case in painstaking detail—with the Court indicating that the evidence easily supported the findings below and, apparently, underscoring its view of the bank’s conduct as egregious. High bar for establishing aiding and abetting liability. The Supreme Court emphasized the stringent requirements for a finding of aiding and abetting liability—particularly the scienter requirement. An aider and abettor “must act ‘knowingly, intentionally, or with reckless indifference’… that is, with an ‘illicit state of mind’” and, to establish scienter, “the plaintiff must demonstrate that the aider and abettor had ‘actual or constructive knowledge that their conduct was legally improper.’” Claims for aiding and abetting liability are “among the most difficult to prove,” the Court stated. Relevant conduct of the Rural Metro financial advisor. According to the Chancery Court and the Supreme Court, the relevant conduct of the Rural Metro financial advisor that supported aiding and abetting liability included that the advisor had: ▪ Been “propelled by its own motives” (primarily to obtain financing and other engagements from the buyer) when determining the timing and nature of the sale process; ▪ Concealed actual or potential conflicts of interest from Rural Metro (including with respect to efforts to provide staple financing to the buyer and to provide financing to buyers of a competitor of Rural Metro, and its leaking information about the Rural Metro process and valuation to the buyer); Page 11 Delaware Supreme Court Affirms Rural Metro (continues on next page) Delaware Supreme Court Affirms Rural Metro (continued from previous page) ▪ Produced only very limited information for the board (including its not providing a valuation of the company as an independent concern); manipulated the financial analyses and other information provided in order to persuade the board to approve the merger; and provided the information to the board only hours before the board meeting at which the merger was approved; and ▪ Provided disclosure for the merger proxy that included material omissions and misstatements. Revlon duties apply to a board from the outset if the board never really considered any strategic alternatives to a sale. The appellants argued that the Chancery Court had incorrectly reviewed the board’s actions at the outset of its process under a Revlon enhanced scrutiny standard. At that time, the appellants asserted, the board was reviewing strategic alternatives and had not made a decision to sell the company. The Supreme Court upheld the Chancery Court’s application of Revlon, citing its 2009 Lyondell holding that enhanced scrutiny applies when “directors [begin] negotiating the sale of [the company].” The Supreme Court reasoned that, although the Rural Metro board had asserted that it was exploring strategic alternatives, the evidence demonstrated that the board and its special committee were set on a sale from the beginning and had never really considered strategic alternatives. Practice points Disclosure of banker conflicts of interest. Based on Rural Metro, as well as subsequent decisions (including Zale), financial advisors must make adequate and timely disclosure of actual and potential conflicts of interests to their clients. Timing. Optimally, disclosure would be made at the outset of the engagement and on an ongoing basis as conflicts may arise thereafter. Board’s obligation to inquire and respond. We note that boards themselves must be proactive in soliciting this information from their financial advisors and must consider the appropriate response to any such disclosure that is made. Mechanics. Practice continues to evolve with respect to the mechanism of disclosure, with some banks making the disclosure in the engagement letter, some in a separate letter to the board, and some in the board book. Disclosure issues. Note that a number of standard bank activities may create potential conflicts of interest that should be disclosed. These could include, for example, a bank’s prior pitches relating to the target company (even if part of a bank’s regular marketing efforts and based on public information) and a bank’s desire to provide staple financing or to obtain other engagements. (Please see our prior memorandum, Chancery Court Ruling Raises Concerns About Bankers’ Prior “Pitches” Leading to Potential Aiding and Abetting Liability in M&A Litigation—Post-Zale Practice Points for Banks and Boards (Oct. 9, 2015).) Board involvement in the sale process. While a board is entitled to rely on its bankers in crafting and implementing a sale process (and it is the bankers, not the board, who are expected to have that expertise), throughout the process the board must be actively engaged, must play a direct role, and (in the words of the Chancery Court in Rural Metro) must not be “passive instrumentalities.” A board must actually run the sale process and seek to ensure that the board is adequately informed—which, based on Rural Metro, involves, at a minimum, understanding the various indices of value that will provide the foundation for the board’s decision whether to approve a proposed transaction. The Chancery Court noted that a well-informed board that had considered all of the relevant issues might have decided to design the sale process just as the Rural Metro board had. In this case, however, according to the court, the conflicts and other problems required that the court view the board’s decisions more skeptically. Viewed in this fashion, the court found that the board’s sale process decisions fell outside the range of reasonableness. Page 12 Banker’s conduct that troubled the court. According to the Chancery Court and affirmed by the Supreme Court: The banker had not disclosed to the board that the banker’s decisions as to the timing of the sale process (i.e., to coordinate it with the sale process of EMS, a competitor of the company), as well as the decision to focus only on financial buyers as potentially interested bidders, served the banker’s interest in seeking to obtain financing engagements from bidders for EMS and seeking to provide buy-side staple financing for the buyer of Rural Metro. The special committee and the banker had been charged by the board with considering strategic alternatives, but they focused only on a sale of the company and did not consider strategic alternatives (including remaining independent). The board had received valuation materials from the banker that were very limited (and that included “false information”); the analyses had been manipulated by the banker to make the proposed transaction appear more attractive than it was; and the materials were provided to the board just hours before the board meeting at which the merger was approved. Although generally aware of the banker’s conflicts, the board had placed no restrictions on the banker’s efforts to seek to provide staple financing for the merger and did not generally control the bank’s activities in connection with the sale process. The board minutes did not appear to reflect what had actually happened (but instead appeared to have been prepared in anticipation of litigation) and did not document the foundations for the board’s decisions. Proxy disclosure. The question remains whether disclosure to the Rural Metro stockholders of the advisor’s potential or actual conflicts of interest, as well as disclosure of the flaws in the sale process (including in the information the advisor had provided to the board), would have eliminated aiding and abetting liability for the advisor. Adequate disclosure in the merger proxy is obviously critical and can go a long way toward minimizing potential liability for conflicts and sale process flaws. However, we expect that there is some point at which conduct that is viewed as sufficiently egregious cannot be absolved by disclosure. (We note the Chancery Court’s discussion to that effect in its September 2015 decision in In re PLX.) We would expect, for example, that, depending on the circumstances, a conflict of interest issue likely could be negated by disclosure; however, knowing and material manipulation of financial analyses, in our view, likely could not. Indemnification. Notwithstanding the limited nature of the Supreme Court’s ruling, the recent increased attention to potential aiding and abetting liability has led to a reconsideration of the standard indemnification provisions in engagement letters. Companies and their advisors should consider the appropriate indemnification arrangements and the provisions should be drafted carefully to reflect the parties’ intentions. Delaware Supreme Court Affirms Rural Metro (continued from previous page) Last year, controversy ensued following the SEC’s issuance of no-action relief to Whole Foods Inc. with respect to its exclusion of a shareholder proposal for proxy access on the basis that, under SEC Rule 14a-8(i)(9), it “directly conflicted” with the company’s own proposal to provide proxy access on different (more restrictive) terms. As a result, in January Change in SEC’s Longstanding Approach to Exclusion of “Conflicting” Shareholder Proxy Proposals Creates Uncertainty Change in SEC’s Longstanding Approach (continues on next page) Page 13 2015, the SEC announced that, pending a review of the “proper scope and application of Rule 14a-8(i)(9),” the SEC would not be issuing any no-action letters with respect to conflicting proposals during the 2015 proxy season. The SEC Staff has now issued a Staff Legal Bulletin stating its policy on conflicting proposals for the 2016 proxy season. The policy stated in the SLB represents a change in the SEC’s longstanding approach to conflicting proposals and, as discussed below, the limits of its application are, at this time, uncertain. SEC issues new SLB applicable to 2016 proxy season. Staff Legal Bulletin No. 14H, issued on October 22, 2015, states that, for the 2016 proxy season, companies may obtain no-action relief to exclude shareholder proposals that “directly conflict” with a company proposal that will be submitted to shareholders at the same meeting only if “a reasonable shareholder could not logically vote in favor of both proposals, i.e., a vote for one proposal is tantamount to a vote against the other proposal”—that is, “they are, in essence, mutually exclusive proposals.” Change in SEC’s longstanding approach to conflicting proposals. Acknowledging that SLB14H represents a change in the SEC Staff’s longstanding approach to “conflicting proposals” exemption under Rule 14a-8(i)(9), the Staff makes clear in the SLB that the exemption cannot be used to exclude proposals that “propose different means of accomplishing an objective, but do not directly conflict” with a company proposal or where “a reasonable shareholder, although possibly preferring one proposal over the other, could logically vote for both.” (The SLB also clarifies that the availability of the exclusion will not be affected by whether the shareholder proposal is binding or precatory or was submitted before or after the company proposal had been developed.) Accordingly, it appears that companies will no longer be able to exclude under Rule 14a-8 many of proposals that in the past have been excludable on the basis that they directly conflicted with a company proposal because the proposed terms were different. Lack of clarity as to the limits of the SEC’s new approach. We note that the extent of the change that will result from the SEC’s new interpretation is not yet clear. The SEC did not clarify in the SLB whether there would be a point (and, if so, what that point would be) at which, although a shareholder proposal and a company proposal are logically consistent in terms of subject matter (e.g., both are in favor of a specified matter), the terms of the two proposals are so different that they could be regarded as being in conflict. In the SLB, the Staff gave the following as an example of proposals that would not be in conflict: (a) a shareholder proposal for proxy access that would permit shareholders holding at least 3% of the stock for at least 3 years to nominate up to 20% of the directors and (b) a company proposal for proxy access that would allow shareholders holding at least 5% of the stock for at least 5 years to nominate up to 10% of the directors. The company could not exclude the shareholder proposal, the Staff explained in the SLB, because: “[B]oth proposals generally seek a similar objective, to give shareholders [proxy access], and the proposals do not present shareholders with conflicting decisions such that a reasonable shareholder could not logically vote in favor of both proposals.” Would the proposals be deemed to conflict, however, if the company proposal would permit only shareholders holding 10% (or 20%?) of the stock for at least 10 years to have proxy access? Those terms, which are so far from the terms of the shareholder proposal, could reasonably be regarded, as a substantive matter, as being a proposal to not provide proxy access, rather than as a proposal to provide proxy access albeit on different terms. How the Staff will deal with this issue awaits further developments. Uncertainty as to proxy advisory firm responses. We note also that it is uncertain how the proxy advisory firms will react to conflicting shareholder proposals. Glass Lewis recently revised its guidelines to outline the factors it will consider when evaluating competing management and shareholder proposals. These are: the nature of the underlying issue; the benefit to shareholders from implementation of the proposal; the materiality of the differences between the terms of the management and shareholder proposals; the appropriateness of the provisions in the context of the company’s shareholder base, corporate structure and other relevant circumstances; and the company’s overall governance profile and responsiveness to shareholders as evidenced by its response to previous shareholder proposals and its adoption of progressive shareholder rights provisions. It is not clear how these guideline will play out in practice. Change in SEC’s Longstanding Approach (continued from previous page) Page 14 We have previously discussed that—in an environment in which the court is using the merger price more frequently as the primary factor in determining fair value—the court appears to continue to struggle with the statutory mandate that the court exclude from the determination of fair value any value that “arises from the merger” itself. Please see our recent related memoranda available on the Fried Frank website: BMC Software: The Court’s Ongoing Incremental Path to Increased Reliance on the Merger Price in Appraisal Cases (and DCF-Related Practice Points) and Adjustment of the Merger Price to Exclude ‘Merger-Specific Synergies’ Will Occur Only in the Rarest of Cases. As discussed in our recent memoranda: The court has not established a certain conceptual framework for considering the issue of adjustment to the merger price. The court continues to grapple with both the fundamental meaning of the statutory mandate and common law mandates relating to adjustment of the merger price, as well as the practical difficulties involved. To date, the court has declined to make an adjustment to the merger price in any appraisal case. In every case in which the court has relied on the merger price to determine fair value, the court, while acknowledging the mandate to exclude merger-specific value, has not in fact made an adjustment (with one exception, which involved an unusual fact situation). The court appears to have taken an even more restrictive view recently—suggesting that it is unlikely that adjustments will be made except in the rarest of cases. With its most recent appraisal decision, Merlin v. BMC Software (Oct. 21, 2015), the court appears to have taken an even more limited view of the types of value that would be excluded from the merger price, and to have raised even further the threshold to meet the burden of proof with respect to quantifying value that would be excludable and establishing that that amount had actually been included in the merger price. Accordingly, we expect that, when the court relies primarily on the merger price, the court will make adjustments to the merger price in only the rarest of cases. Nonetheless, it is clear that the court now routinely and readily acknowledges the principle that merger-specific value should be excluded. Thus, conceivably, if a respondent company presents an appropriate record that identifies and quantifies merger-specific value, and that establishes that that value has been included in the merger price, the court may make an adjustment. We offer the following practice points for consideration by acquirors, target companies and dissenting stockholders as they evaluate how to best establish a record with respect to the issue of adjustment of the merger price. Acquirors and dissenting stockholders should consider the nature of the target’s sale process to evaluate how likely it is that the court would rely on the merger price in determining fair value. The court’s recent reliance on the merger price to determine appraised fair value has been in cases in which the merger price has been derived through a robust sale process that has included active shopping of the target company. Accordingly, acquirors will have a better sense of the likely appraisal risk, and stockholders considering seeking appraisal will have a better sense of the likely potential reward, if they understand the target company’s sale process. Acquirors and stockholders considering seeking appraisal should carefully review the target’s proxy statement disclosure about the sale process to form a judgment as to whether the court is likely to rely on the merger price. Acquirors and dissenting stockholders should consider the reliability of the target company’s projections in evaluating how likely it is that the court would rely on the merger price to determine fair value. In all of the cases to date in which the court has relied primarily on the merger price to determine fair value, not only has the court Practice Points Relating to Adjustment of the Merger Price in Appraisal Cases—the Effect of BMC Software Practice Points Relating to Adjustment (continues on next page) Page 15 Practice Points Relating to Adjustment (continued from previous page) viewed the merger price as having been particularly reliable due to the nature of the sale process, but the court has regarded the results of the financial analyses (such as a discounted cash flow analysis) as particularly unreliable due to the inputs—most often, the target company’s projections—being, in the court’s view, unreliable. Thus, in evaluating whether the court is likely to rely primarily on a DCF analysis or, instead, the merger price, acquirors and stockholders considering seeking appraisal should evaluate the reliability of the target’s projections. Stockholders considering seeking appraisal should carefully review the target company’s proxy statement disclosure about its projections. Acquirors, to the extent appropriate, should seek to understand from the target whether: the company prepares annual projections on a regular basis, who prepares them, how they are prepared, and what the nature of the projections is (1-, 3-, or 5-year); the projections are subject to review by the board and what the extent of the review is; the projections utilized in the sale process were prepared other than in the ordinary course; there are any indications that the projections were modeled to be “aggressively” optimistic or pessimistic, or were prepared in anticipation of the sale process, or otherwise may not reflect the management’s best view of the company’s future; there were any unusual factors relating to the nature of the company, or developments relating to the company, that would have made it particularly difficult to make reasonable forecasts; the projections have been used an any other manner that suggests the level of confidence management has in them (such as having been provided to banks or other financial institutions); and from an historical point of view, the projections have been reliable (i.e., the record of projected results versus actual results). Respondent companies should argue for reliance on the merger price to determine fair value when appropriate. Most appraisal parties (petitioners and respondent companies alike) have relied primarily on a DCF analysis when presenting their view of fair value to the court. Given the court’s recent increased reliance on the merger price when (a) the merger price has been derived through a sale process that has involved active shopping and (b) the inputs to the financial analyses (such as the target company’s projections) are regarded by the court as unreliable, respondent companies, when appropriate, in addition to presenting their financial analysis, should present arguments as to why the court should rely primarily on the merger price. Of course, the court can be expected to be more inclined to rely on the merger price when the DCF result is close to the merger price. (We note that, possibly, the court might in the future broaden its receptiveness to reliance on the merger price (a) even when the sale process has not involved active shopping, so long as there has otherwise been an effective market check and/or (b) whether or not the financial analysis inputs are regarded as unreliable.) Acquirors should seek to establish the best possible record to convince the court to make a downward adjustment to the merger price. As discussed above, even if those cases in which the court has found that certain value is properly excludable from the merger price, the court has declined to make any adjustment, in each case citing an “insufficient record” as to (i) which synergies or cost-savings are merger-specific; (ii) if there are any, what the actual value is; and (iii) whether that value has been included in the merger price. As we have noted, the court’s conclusion in every case that the record is insufficient appears to have been driven in part by the court’s general disinclination to make adjustments to the merger price. However, given that the court’s thinking on both the conceptual and practical issues relating to adjustment of the merger price continue to evolve, acquirors should consider how to establish the best possible record to support an adjustment. An acquiror should consider taking the following steps: Practice Points Relating to Adjustment (continues on next page) Page 16 Practice Points Relating to Adjustment (continues on next page) Identify, categorize and quantify expected merger synergies and cost-savings—particularly, any unique value that the acquiror brings. Typically, an acquiror will have analyzed and announced, within a range, the value of the synergies expected from the merger. In performing this analysis, acquirors should be aware that, in the appraisal context, certain types of expected synergies and cost-savings may, and others would not, support a downward adjustment to the merger price. An acquiror should describe in detail, and substantiate a value for, any expected synergies and cost-savings that could be characterized as “arising from the merger itself” or as not being part of the company’s “going concern value” (as these concepts have been interpreted by the court). These would include synergies and cost-savings that (a) relate to unique characteristics of the buyer, (b) could not be achieved by the target on its own without this or another transaction, or (c) relate to a change in form of the corporation (such as a going-private transaction (which the BMC Software decision considered to be a change of corporate form) or a conversion from “C” corporation status to “S” corporation or partnership form). The acquiror should identify what part of its offer price is based on these types of expected cost savings or synergies. References to anticipated savings embedded in assumptions for projections or in an investment memorandum may not provide a sufficient record. The company’s investment banker and legal counsel should be an integral part of the process. Internal company documents, and documents prepared by the investment banker, should be carefully reviewed so as to be consistent with the acquiror’s views of merger-related synergies and cost savings. Quantify any control premium. As discussed above, the court has not addressed the issue of exclusion of a control premium from the merger price (and, particularly after BMC Software, we conclude that the court is likely to have the same reluctance to exclusion of a control premium as it has had with respect to exclusion of merger synergies). However, an acquiror could consider determining what part of the merger price is represented by a control premium (less—to avoid double-counting—the amount of any such premium that is attributable to merger synergies that are themselves excludable for fair value purposes) and establishing a foundation to support that determination so that an argument for exclusion of the amount for fair value purposes could be made. We note that the calculation of a control premium amount is complex for a number of reasons, including because part of the premium may be attributable to merger-specific synergies that are themselves excludable from fair value (and could not be counted twice in determining reductions). With respect to any value that may be excludable from the merger price, acquirors should substantiate (a) the amount and (b) that the value was included in the merger price. The court has established a high threshold for establishing (a) and (b). In BMC Software, the court indicated that the acquiror’s identifying certain value for synergies or cost savings in its investment analyses was not sufficient to establish either the appropriate amount or the fact that that amount was included in the merger price. Moreover, the court suggested that the acquiror’s IRR analysis “rais[ed] the question of whether the… purported going-private savings outweighed the Buyer Groups’ rate of return that was required to justify the leverage presumably used to generate those savings.” The court wrote: “Here, the Respondent’s expert did not opine on the fair value of the company using a deal-price-less-synergies approach. Instead, the Respondent offered only the testimony of the buyer and its internal documents to show that the purported synergies were included in the analysis.” Accordingly, acquirors should consider: having a separate, reasonably detailed statement outlining the components of the merger price determination, with supporting documentation for the amounts listed; having the expert opine on the fair value and the exclusion of synergies in a “deal-price-less-synergies” format— and from the outset (rather than, as is typical, addressing the synergies supplementally after the court has determined fair value); and doing at least two (if not more) IRR analyses so that the impact of the expected synergies on rate of return is broken out—i.e., one analysis would reflect DCF without synergies that “arise from the merger” or are not part of “going concern value,” and one with synergies—demonstrating that the acquiror could not pay the price and achieve the required rate of return without the expected synergies. Practice Points Relating to Adjustment (continued from previous page) Page 17 Practice Points Relating to Adjustment (continued from previous page) To the extent that the court may be expected to rely on the merger price to determine fair value, a dissenting stockholder would also want to: Consider whether there are “negative synergies.” A petitioner should consider whether there is an expectation of negative synergies in a transaction (such as regulatory-driven divestitures of assets, which, due to timing or the nature of the assets, may be expected to have to be effected at less than fair value). A unique cost to the acquiror resulting from the transaction could be used to support an upward adjustment in the merger price to determine fair value or (more likely) as an offset against the exclusion by the court of any positive synergies established by the acquiror. We note that, as complicated as it appears to be to establish adjustments for positive synergies, it will likely be at least as difficult to establish negative synergies. Consider developments at the company between signing of the agreement and the merger. The court has indicated that increases in value of the target company (even if caused by the acquiror) between signing and closing would be value of the company to which the dissenting stockholders are entitled, requiring an upward adjustment in the merger price. No upward adjustment of this nature has in fact been made. However, especially in the case of a long delay between signing and closing (for regulatory reasons, for example), dissenting stockholders should consider whether there have been developments increasing the value of the company. Conversely, dissenting stockholders should also follow developments that may negatively affect the value of the company— and, if the decline in value is significant, dissenting stockholders may want to consider withdrawing the appraisal request (if during the time period permitted by statute). Consider the company’s “future prospects.” The court has held that, for purposes of determining fair value, the “operative reality” of a company includes “future prospects” that are “known or knowable” at the time of the merger. Dissenting stockholders should consider whether, under this potentially broad concept (that, we note, in the case of a long period between signing and closing can be considered in hindsight based on actual developments), there are “future prospects” that it can be argued were not part of the merger price and would require an upward adjustment in the merger price. Not argue for any downward adjustment from the merger price. In Ramtron, the petitioner presented evidence for a nominal (three cents) downward adjustment in the merger price. The respondent company argued for a significant downward adjustment based on expected synergies. The court, without discussion, selected the petitioner’s suggested adjustment. Importantly, Ramtron has been the only case in which the court has actually made a downward adjustment to the merger price—and the court may well not have absent the petitioner’s concession that some downward adjustment was required. For Buyers and Sellers of Portfolio Companies, Practice Points Arising from Chancery Court’s Prairie Capital Decision In a recent decision relating to the sale of a portfolio company by one private equity firm to another— Prairie Capital v. Double E (Nov. 24, 2015)—the court provided important guidance with respect to a buyer’s ability to make post-closing fraud claims against a portfolio company’s executives and its private equity fund sellers. Please see our memorandum, Chancery Court Provides Guidance on Post-Closing Fraud Claims by Buyer of Portfolio Company (available on the Fried Frank website), for a discussion of the decision. For Buyers and Sellers of Portfolio Companies (continues on next page) Page 18 For Buyers and Sellers of Portfolio Companies (continues on next page) Most importantly, the decision serves as a reminder that, in a sale agreement that includes a typical non-reliance provision (i.e., a statement that the buyer has not relied on statements made or information provided outside the agreement), the representations and warranties set forth in the sale agreement will affect the extent to which the buyer can bring not only indemnity claims but also fraud claims. At the same time, the court broadened its view as to the types of non-reliance provisions that would be effective in barring extra-contractual claims. In Prairie Capital, the buyer had conditioned its offer on the portfolio company’s meeting certain sales targets. The seller allegedly falsified the books and records and lied to the buyer in order to make it appear that the sales targets had been met. Notwithstanding the egregious factual context, at the pleading stage, the court ruled (consistent with its 2006 Abry decision) that, based on the non-reliance provision in the sale agreement, the buyer could bring a fraud claim only to the extent that it was based on a breach of a representation and warranty set forth in the agreement. Although most of the fraud claims made in Prairie Capital were not dismissed, the court’s disposition of each claim was based on a detailed review of the representations in the agreement to determine whether, by their terms and the dates as of which they spoke, they covered the alleged fraudulent conduct. The decision also confirms that a well-drafted non-reliance provision will be respected by the court and will preclude a buyer from making a fraud claim that is based on extra-contractual statements. The court indicated that, contrary to what has been suggested in some precedent, no “magic words” are required to make a non-reliance provision effective, so long as the provision clearly indicates the parties’ intention that the buyer disclaims reliance on extra-contractual statements. The following practice points arise from the court’s opinion. Practice Points for Buyers Importance of the breadth of the sale agreement representations and warranties. Based on Prairie Capital, the representations and warranties set forth in the sale agreement, as defined by the qualifiers and dates included in the representation, will affect not only a buyer’s ability to bring indemnification claims but also its ability to bring fraud claims. We note that, in any case in which the truth of certain specific information is particularly key to the buyer’s determination to enter into the transaction (such as, in Prairie Capital, the truth of the Company’s having met a specific sales target just prior to signing), a buyer should consider whether it could better ensure that the information is precisely covered if it made that information the subject of a separate representation (without the qualifications, dates or other limitations applicable to a broad general representation). Fraud claims will not be subject to the limitations on indemnification set forth in the sale agreement. It should be kept in mind that, to the extent a buyer can bring a fraud claim for a misrepresentation of the seller, the claim will not be subject to the caps, deductibles, baskets, timeframes or procedural restrictions set forth by the parties in the sale agreement with respect to indemnification for breaches of representations. Consider seeking to include a fraud carve-out not only in the exclusive remedy provision but also in the non-reliance provision. In response to the court’s interpretation in Prairie Capital of the fraud carve-out clause in the exclusive remedy provision, a buyer should consider seeking to include a fraud carve-out not only in the exclusive remedy provision but also in the non-reliance provision. The double carve-out would make it clear that the parties intend not only to eliminate indemnification as the exclusive remedy for a fraud claim, but also to override the non-reliance provision’s bar to extra-contractual fraud claims. Indemnification claim should be drafted to cover the specific claim. Consistent with the court’s trend in recent years, the court rejected the concept of a “placeholder” indemnification claim. The court rejected a claim that was supported by allegations in the pleadings but had not been described in the indemnification notice provided under the agreement. Buyers making indemnification claims should provide specific support in the indemnification notice and not rely on being able to make more specific allegations in litigation pleadings. For Buyers and Sellers of Portfolio Companies (continued from previous page) Page 19 For Buyers and Sellers of Portfolio Companies (continued from previous page) Practice Points for Sellers Importance of the breadth of the sale agreement representations and warranties. As noted, the breadth of the representations in the sale agreement will affect not only a seller’s potential liability for indemnification claims, but also for fraud claims. Sellers must consider what to do when projections provided to buyers become inaccurate at a later stage in the sale process. Although not the situation present in Prairie Capital, the decision serves as a reminder that, even when fraudulent conduct is not at issue, during what can be an extended sale process, the selling parties may come to have knowledge that the projections provided to the buyer at an earlier stage have become inaccurate. The decision underscores the importance of considering the appropriate timing, form, and extent of disclosure to the buyer of this type of development. Although the court ruled that the effectiveness of a non-reliance provision will not depend on the use of “magic words,” previously judicially endorsed formulations should be employed to avoid the issues that arose in Prairie Capital. The court upheld the effectiveness of the non-reliance provision in Prairie Capital despite the fact that the provision was not formulated as the court in past precedent had suggested would be required. Nonetheless, issues relating to the effectiveness of a non-reliance provision should be mitigated if, as the court has previously required, the provision includes (i) words specifically stating that the buyer has not relied on extra‑contractual statements; and (ii) a specific reference to non-reliance not only on misrepresentations but also on “omissions or the concealment of material information.” Consider seeking to incorporate into the sale agreement the court’s interpretation of the fraud carve-out in Prairie Capital. A seller should consider seeking to include in the agreement a statement of the parties’ intention that the fraud carve-out in the exclusive remedy provision affects only the remedy that is available if a fraud claim otherwise can be made and does not expand the basis on which a fraud claim can be made—in other words, consistent with how the court interpreted the fraud carve-out in Prairie Capital, that the carve-out is intended to eliminate indemnification as the exclusive remedy for a fraud claim but does not override the non-reliance provision’s bar to extra-contractual fraud claims. Other agreement provisions that might mitigate the risk associated with post-closing fraud claims. We note that post-closing fraud claims span a continuum—from those that are made by a buyer who (as alleged in Prairie Capital) was “duped” into agreeing to a transaction based on false representations that were apparently knowingly made, to those made by a buyer who simply has “buyer’s remorse” and bases fraud claims on representations that turned out to have been false but were possibly negligently or even innocently made. Sellers seeking to mitigate the risk of post-closing fraud claims might consider (to the extent permissible under state law) seeking to (i) contractually limit the persons and entities against which any claims (including fraud claims) could be made, and (ii) provide for alternative arrangements for the payment of fees and expenses incurred in defending a fraud claim unless the buyer prevails in the litigation. Representations and warranties insurance. We note that the trend has been toward private equity sellers increasingly relying on representations and warranties insurance to cover their potential liability for breaches of representations and warranties. When R&W insurance is employed, a seller should seek to have the insurance coverage mirror to the extent possible the seller’s indemnity obligations under the sale agreement. Importantly, sell‑side insurance generally does not cover fraud claims, and the seller is required to certify to the insurance company that, to its knowledge, the representations and warranties set forth in the agreement are true and correct. A seller should keep in mind that any fraud claim by the insurance company would, of course, be unaffected by limitations on indemnification or fraud carve-outs set forth in the sale agreement. Indemnification of portfolio company executives. As the court discussed in Prairie Capital, the portfolio company officers through whom the portfolio company makes fraudulent misrepresentations can be held accountable for the company’s fraud. Indemnification provisions in the company’s charter and/or executive employment agreements should be reviewed to ensure that they reflect the parties’ intentions with respect to indemnification of executive officers for this potential liability. Page 20 M&A/Private Equity Group Partners: If you would like to receive Fried Frank M&A Quarterly via email, you may subscribe online at friedfrank.com/subscribe. New York Abigail P. Bomba firstname.lastname@example.org Jeffrey Bagner email@example.com Andrew J. Colosimo firstname.lastname@example.org Aviva F. Diamant email@example.com Steven Epstein firstname.lastname@example.org Christopher Ewan email@example.com Arthur Fleischer, Jr.* firstname.lastname@example.org Peter S. Golden** email@example.com Mark Lucas firstname.lastname@example.org Tiffany Pollard email@example.com Philip Richter firstname.lastname@example.org Steven G. Scheinfeld email@example.com Robert C. Schwenkel firstname.lastname@example.org David L. Shaw email@example.com Matthew V. Soran firstname.lastname@example.org Steven J. Steinman email@example.com Gail Weinstein* firstname.lastname@example.org Washington, DC Jerald S. Howe, Jr. email@example.com Brian T. Mangino firstname.lastname@example.org London Dan Oates email@example.com Graham White firstname.lastname@example.org Frankfurt Dr. Juergen van Kann email@example.com *Senior Counsel **Of Counsel A Delaware Limited Liability Partnership. The articles included in Fried Frank M&A Quarterly are general in nature and are not intended to provide legal advice with respect to any specific situation confronted by our clients or other interested persons. 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