Not surprisingly, no court considering any of the recent sales of major financial institutions impelled by the credit crisis has been critical of these transactions. On December 4, the New York Supreme Court dismissed an action seeking damages from JPMorgan and the directors of Bear Stearns based upon JPMorgan’s acquisition of Bear Stearns. The following day, the North Carolina Business Court refused to enjoin the pending acquisition of Wachovia by Wells Fargo. Both courts held the decision of directors to sell their company to be protected by the business judgment rule.*
The Decision to Sell
Both the Bear Stearns and Wachovia decisions cited similar, but until the current credit crisis, unusual factors in concluding that a board’s decision to enter into a transaction was a proper exercise of business judgment:
- the rapidly deteriorating financial condition of Bear Stearns and Wachovia justified prompt action and a compressed decision-making process,
- failure to act very likely would have resulted in liquidation and a loss of all or most of stockholder equity,
- intense regulatory pressure to pursue a transaction, including, in the case of Wachovia, an FDIC intention to place it in receivership,
- given the time constraints and the generally bleak economic and credit market conditions, the absence of credible third party bidders or sources of additional capital, and
- the failure of the company would pose “systemic risks” to a “still precarious financial system”.
In addition, more common factors typically cited in support of strategic combinations were mentioned:
- a review of alternatives with experienced legal and financial advisors (including the likely loss of all stockholder value in bankruptcy if there were no were merger or sale transaction),
- the well-established Delaware law principle (followed by the North Carolina court in its Wachovia decision) that a strategic stock-for-stock merger is reviewed under the deferential business judgment standard rather than the heightened scrutiny applicable to a sale of a company for cash or transactions involving conflicts of interest,
- the receipt of a fairness opinion from the board’s financial advisor, and
- a majority of the directors were disinterested and all non-management directors would be expected to lose their directorships upon consummation of the transaction.
Each judge considering these transactions was aware that interfering with these takeovers could further destabilize the financial system, increase the cost of any governmental or third party rescue, and erode confidence in the ability of regulators and the market to salvage failing institutions. (In his April Bear Stearns opinion, Vice Chancellor Parsons stated, “What is paramount is that this Court not contribute to a situation that might cause harm to a number of affected constituencies, including U.S. taxpayers and citizens, by creating the risk of greater uncertainty.”) Moreover, the desirability of providing directors of other troubled companies with the confidence to take appropriate action to deal with other possible future emergencies created by the financial crisis may have contributed to the emphatic affirmation of the applicability of the business judgment rule and the absence of any criticism of director conduct.
Recognizing that the directors were confronted with an unprecedented “financial tsunami” (in the words of the Wachovia court) and that their decisions were unlikely to create precedent easily applicable to more routine acquisition transactions not having significant implications for the stability of the national economy and financial system, these decisions could have been based solely on the profound exigencies of the situation. However, each of the Delaware, New York and North Carolina courts stated that it was applying well-settled principles of law. Unlike Lincoln, who suspended habeas corpus, these courts affirmed that directors remain subject to the same standards that apply in less desperate times. These fundamental principles, such as fiduciary obligations to stockholders, the business judgment rule, Revlon duties and the Unocal test of deal protection devices, have always been applied in the context of particular facts and are both strong enough and flexible enough to support the exercise of rational business judgment by disinterested directors in extraordinary circumstances.
It is in the review of deal protection rather than the decision to enter into a transaction that these opinions are most interesting. Both the Bear Stearns and Wachovia mergers included an imposing array of deal protection devices when compared to the more common “no shop” and termination fee provisions. Both transactions included the sale of approximately 40% voting power to the acquirer and a “force the vote” obligation (that is, even if a more favorable acquisition proposal were received, the original transaction must be submitted for stockholder consideration). JPMorgan also received a “crown jewel” asset lock-up in the form of an option to purchase the Bear Stearns headquarters building.
The New York court, applying Delaware law to its consideration of the Bear Stearns lockups, held that these protections were subject to the business judgment standard of review, in an apparent departure from the widely accepted view that deal protections are subject to the Unocal standard of reasonableness in relation to the threat posed (as interpreted in Unitrin to mean that protections may neither coerce stockholder approval nor preclude alternative transactions). Nevertheless, the New York court nimbly avoided controversy by concluding that the acquisition of Bear Stearns by JPMorgan not only met the requirements of the business judgment rule, but also satisfied the more demanding standards of Revlon (which imposes a duty to maximize stockholder value if a company is sold), Unocal, and Blasius (which requires a compelling justification for interference with stockholder voting rights).
The Wachovia court, applying North Carolina law, also held that a good faith and informed decision to include deal protection measures in a merger transaction is entitled to the benefit of judicial deference absent a showing that the devices prevented directors from performing their fiduciary duties (presumably, to consider and act upon subsequent acquisition proposals) or were coercive. (This resembles the Unocal standard with the burden of proof shifted to those attacking a board’s decision.)
Both courts upheld the armory of devices erected to protect each transaction, with one limited exception. Although each decision concludes that the lockups and other deal protection provisions did not completely eliminate the possibility of a sale to a different acquirer and, therefore, were not preclusive, the overriding rationale for the favorable court decisions was the need to immediately stop the “run on the bank”, stabilize these institutions, and preserve value by providing certainty that the rescues of the financial institutions would be completed. In the case of Bear Stearns, this deal certainty was used to induce JPMorgan to guarantee Bear Stearns obligations, including exposure to counterparties to credit default swaps and other derivatives, at the time the acquisition agreement was announced in order to preserve the viability of Bear Stearns. Similarly, Wachovia received the immediate benefit of the strong balance sheet of Wells Fargo simply by the announcement of the deal as well as more attractive financial terms than those proposed by Citigroup. In addition, Wells Fargo was willing to proceed without government assistance in contrast to Citigroup’s insistence on FDIC participation in its proposed transaction, which made the Wells Fargo transaction preferable to the regulator and less costly to the US taxpayer. In addition to the compelling justification in these unique circumstances of certainty to stem the rapid deterioration of the selling companies, the courts also relied upon a number of other factors in affirming the validity of the deal protection devices:
- the merger agreements and deal protection devices were agreed to at the true end of the auction because the financial plight of both Bear Stearns and Wachovia was known before the transactions, the bankers for each company had contacted numerous potential acquirers, and any further delay would have resulted in bankruptcy or liquidation with loss of equity and debt value and great disruption to the financial system,
- JPMorgan was the only financially sound party with the resources to settle the marketplace by standing behind the Bear Stearns obligations in a manner acceptable to the Federal Reserve and Wells Fargo had outbid Citigroup and was preferable to the FDIC because it did not demand government assistance in the rescue,
- the courts stated that the absence of other bidders was not a result of the deal protection devices, but rather a reflection of the realities of the marketplace,
- neither Wachovia nor Bear Stearns had given its merger partner absolute control—approval of the proposed acquisition by some of their public stockholders was required for the deals to be completed because Wells Fargo and JPMorgan were not given an absolute majority of the voting power and, therefore, could not unilaterally approve their transactions by themselves (the upward renegotiation of the value paid by JPMorgan after the announcement of its initial $2 per share acquisition agreement may, in part, be attributable to the well publicized negative reaction of certain Bear Stearns stockholders to the original deal although the modification of JPMorgan’s guarantee of Bear Stearns obligations in the event the transaction did not close also was an important factor), and
- Bear Stearns and Wachovia had little leverage in resisting demands for deal protection devices in light of the threat of their imminent collapse, but, nevertheless, were able to negotiate less intimidating protections by reducing the voting power granted to the acquirers and, in the case of Bear Stearns, successfully resisting a demand for an option on its prime brokerage business.
The only deal protection measure not approved by either the Bear Stearns or Wachovia court was a prohibition on the redemption of the voting preferred stock issued to Wells Fargo for eighteen months. The North Carolina court found that extending the substantial voting rights of Wells Fargo well beyond the time of a Wachovia stockholder vote on the Wells Fargo merger would unnecessarily impede the Wachovia board’s ability to seek other merger partners if Wachovia stockholders rejected the Wells Fargo transaction. Unlike the other deal protection measures, according to the court, this “voting tail” served no beneficial purpose and was invalid. (Interestingly, while in keeping with certain North Carolina precedent, this holding is inconsistent with a Delaware decision permitting a target company to agree not to sell itself for eighteen months if its stockholders voted down a proposed merger; but, it is in accord with decisions striking down so-called “dead hand” or delayed redemption poison pills, which prohibit their redemption during a specified time period and, therefore, prevent directors from selling their companies during that period.)
No Target Stockholder Claims Against Acquirer
Both the Wachovia and Bear Stearns opinions also provide reassurance to acquirers that using all the leverage they have in negotiations and driving a hard bargain should not give rise to liability under a theory that they aided and abetted a breach of fiduciary duty by the directors of the selling company. Acquirers are named in litigations brought by stockholders of selling companies because if a transaction is consummated, an award of money damages is generally the relief that can be sought for claims that a company was sold for too low a price. However, even assuming target company directors breached their fiduciary duties by agreeing to a sale transaction, exculpatory provisions in most company charters will limit director personal liability to instances of bad faith. Consequently, a claim of aiding and abetting a breach of fiduciary duty, which would not require a showing of director bad faith, might appear to be an attractive way to circumvent the obstacle to monetary recovery posed by the exculpatory provisions. However, the Delaware courts have consistently rejected claims of aiding and abetting liability in situations in which there is arm’s-length bargaining between unrelated parties. (For instance, aiding and abetting claims were dismissed in the Lear Holdings acquisition litigation, in which the grant of a termination fee upon a “naked no vote”-- selling company stockholder rejection of the sale when there is no competing acquisition proposal pending—was attacked, and in the Huntsman/Lyondell Chemical litigation, in which the plaintiffs attempted to hold the acquirer liable for alleged breaches by selling company directors to obtain the highest sales price.) The Wachovia and Bear Stearns courts followed this precedent and reaffirmed that, if the selling company is acting through disinterested directors, exploiting the extreme economic duress of the seller in negotiations will not give rise to aiding and abetting liability.
Obviously, the recent takeovers of major financial institutions are occurring in an economic environment in which courts will be reluctant to interfere absent the most egregious facts. Greater judicial tolerance of the structuring of emergency transactions, however, does not mean that long-established principles of director duties are discarded. Indeed, each of the boards of Bear Stearns, Wachovia and Merrill Lynch followed a process which permitted directors to make an informed decision about alternatives even in a compressed timeframe. Boards in less desperate situations should follow this lead by carefully reviewing with their managements and advisors all strategic alternatives available before committing to a particular transaction.