Page 1 Fried Frank Authors Michael J. Alter Nathaniel L. Asker Abigail Pickering Bomba Andrew J. Colosimo Warren S. de Wied Aviva F. Diamant Steven Epstein Christopher Ewan Arthur Fleischer Jr. Andrea Gede-Lange Peter S. Golden David J. Greenwald Alan S. Kaden Randi Lally Mark Lucas Scott B. Luftglass Brian T. Mangino Brian Miner Bernard A. Nigro Jr. Philip Richter Robert C. Schwenkel David L. Shaw Peter L. Simmons Matthew V. Soran Steven J. Steinman Gail Weinstein M&A/PEQUARTERLY A quarterly roundup of key M&A/PE developments 2nd Quarter 2016 Fried Frank M&A/PE Quarterly Copyright © 2016. Fried, Frank, Harris, Shriver & Jacobson LLP. All rights reserved. Attorney Advertising. Activism Without Leverage (continues on next page) It was, in many ways, a common activist situation. Crestwood Equity Partners, a midstream energy company, experienced a steep decline in the value of its equity, with the limited partnership interests having declined more than 80% over the course of 2015. In December 2015, an activist, Raging Capital Management, which had acquired an almost 5% equity stake in Crestwood, approached the Crestwood board with recommendations for improving the value of the company’s partnership units. After discussions with Raging Capital, Crestwood took steps to address most of the activist’s recommendations. Specifically, in response to the recommendation to improve the EBITDA distribution coverage ratio and to reduce leverage over time, Crestwood reduced the partnership distributions (to an even greater extent than Raging Capital had recommended); in response to the recommendation to reduce leverage, Crestwood effected a tender offer for $250 million of three classes of outstanding debt; and, in response to the recommendation to explore asset sales and other strategic alternatives, Crestwood entered into a significant third party joint venture, with its asset contributions creating an implied market value for its interest in the venture of almost $1 billion. (The one recommendation made that Crestwood did not implement was a direct partnership unit buyback program.) The program was well received by the market and Crestwood has achieved a substantially higher unit market price. Crestwood Underscores Potential for Activism Without Leverage Page 3 Earnouts—Practice Points for Avoiding Post-Closing Disputes Page 9 Mitigating the Risk of Legacy Board Factions After a Stock Merger—Cogentix Page 13 The Changing Game Theory of Delaware Appraisal—Impact of Recent Amendments to the Delaware Statute and the Dell Decision Page 19 Delaware Supreme Court Upholds Decision on Mis-Valuation of Cancelled Stock Options—CDX Page 21 Practical Points on Antitrust Planning, Divestiture Packages, and Reverse Termination Fees Page 25 Delaware Update – Zale, Volcano, Energy Transfer, Dieckman Page 30 NY Update – Kenneth Cole, Central Laborers, Ambac Inside Page 2 Activism Without Leverage (continued from previous page) Activism Without Leverage (continues on next page) What was unusual, however, was that the activist was successful despite having had no source of leverage with which to seek to induce the board to engage with it and to consider and implement its recommendations. As is typical in the master limited partnership context, the Crestwood partnership agreement vested management of the partnership in its general partner, and provided no viable path to removal of the general partner or voice in management by the limited partners. In addition, as permitted under Delaware law—and underscored by a number of recent Delaware Court of Chancery decisions, including, Brinckerhoff v. Enbridge Energy (April 29, 2016), Dieckman v. Regency (Mar. 29, 2016), and El Paso Pipeline Partners, L.P. Derivative Litigation (Apr. 20, 2015)—the partnership agreement eliminated all fiduciary duties of the general partner to the limited partners. Thus, there was no judicial or equity-holder check on actions by the general partner, including with respect to interested transactions or other actions that might not be supported by the equity-holders. As a result, there was no credible explicit or implicit threat of Raging Capital, as a limited partner, commencing a proxy contest to require action by, or the removal of, the general partner. What are the special circumstances under which activism-without-leverage may be effective? Importantly, the Crestwood general partner had a reputation as being a strong sponsor and had a history of strong support for Crestwood. The general partner had undertaken numerous initiatives to create value that would be recognizable by the market— such as consummating a roll-up merger that eliminated incentive distribution rights of the general partner; a 10-for-1 reverse stock split; a joint venture between Crestwood and an affiliate of the general partner, that was favorable to the partnership, to expand the business in a highly productive oil basin; and exploration of a sale of the company. In 2015, the general partner and its affiliates had commenced a program to buy a significant amount of the Crestwood limited partnership units—evidencing their belief that the units were undervalued due to market dislocation and aligning their interests with the limited partners. In addition, the Crestwood senior management team was well-respected, and the CEO had purchased a significant number of limited partnership units, adding to his already meaningful stake. In the Crestwood situation, the steep decline in the value of the limited partnership units had arisen due to selling pressure following what appeared to be a failed process in selling the company (with no transaction consummated at a time that the company was selling at a much higher value and despite multiple potential partners emerging). There was also selling pressure due to energy industry concerns (i.e., low oil prices) and collapse in MLP stock prices generally; increased risk relating to certain Crestwood properties; and selling to capture the significant tax losses. However, in Raging Capital’s view, Crestwood had: numerous scarce and/or strategically advantaged assets; despite high leverage, a strong financial position; and a sponsor with a history of good management of and strong commitment to the partnership, whose interests were aligned with the other equity holders. Importantly, Raging Capital had a well-considered, comprehensive “Crestwood Comeback” plan that focused on longterm value creation. Notably, the recommendations were business-oriented rather than control-oriented, were measured and did not call for dramatic changes, and were focused on perceived needs in the context of a significantly changed macro-economic environment for the company. We note, further, that the letter Raging Capital sent to the Crestwood board, outlining its recommendations, opened by complimenting the Crestwood board and management for “executing on important initiatives” and closed with thanks to the board for its “consideration and ongoing stewardship.” The Crestwood situation highlights that an activist may determine that there is a potential for activism-withoutleverage to be effective when: The target company has highly valuable assets, but considerable, irrational market dislocation, so that the shares or units are significantly undervalued; The target company directors and/or senior management are competent, capable of considering and making changes, and have evidenced an interest in shareholder value creation; Page 3 Earnouts—Practice Points for Avoiding (continues on next page) Activism Without Leverage (continued from previous page) The target company directors and/or senior management have been actively buying company equity, evidencing a belief in and commitment to the company and aligning their interests with the other equity holders; and The activist has concrete, long-term oriented, business-focused (rather than control-focused) recommendations, and adopts a tone of constructive engagement. It bears emphasis that the core of activism is the pressure that an activist can bring to bear on a company—and, in most cases, activism-without-leverage is not likely to be effective notwithstanding the “wisdom” of the activist’s agenda. However, in the ever-expanding world of activism, with even the largest and best performing companies vulnerable to activist approaches, the Crestwood situation indicates that activists may, under certain circumstances, invest in and recommend changes at MLPs, controlled companies, or other companies where the corporate structure and governance preclude or limit traditional routes to leverage by the activist. Those decisions will be based on the activist’s view of the attractiveness of the investment opportunity, balanced against (i) the degree to which the activist’s business recommendations are compelling, (ii) the likelihood that the controllers will be open to consider the recommendations, and (iii) the degree of leverage, if any, that the activist may be able to bring to bear on the company. Leverage in controlled situations will range, on a continuum from, in an MLP situation, little or none, to, in companies with a controlling stockholder, potentially effective leverage from the ability to run a proxy contest for a precatory vote of equity holders, to make recommendations public, and/or, perhaps most importantly, to communicate and engage with creditors, rating agencies, and other company constituencies about the activist’s recommendations. Crestwood highlights the potential effectiveness of longer-term thinking and constructive, non-self-interest-focused recommendations by activists, as well as the possibility of openness to new ideas and constructive engagement with activists by companies—both of which have become more prevalent as activism has matured and company attitudes about shareholder engagement have evolved. Earnouts—Practice Points for Avoiding Post-Closing Disputes Recent cases underscore that earnouts often only delay disputes—transforming disputes over valuation that arise during negotiation of the deal price into disputes over the earnout that occur both during and at the end of the earnout period. Although an earnout is often regarded as an easy route to facilitating a transaction when the buyer and seller of a target business have widely disparate views as to the likely future performance of the business, it should be kept in mind that earnouts often involve negotiating and drafting challenges that can be as or more difficult than any other part of the acquisition agreement, and they consistently lead to post-closing disputes (often involving litigation or, if the parties have provided for it, arbitration). When parties consider utilizing an earnout, they should take into account the points outlined below; take steps to try to mitigate the risk of postclosing disputes relating to the earnout; and consider mechanisms for resolving disputes that do arise. Key Points Prevalence of post-closing disputes. Earnout disputes often arise due to the parties’ differing views as to how the business has performed post-closing, with the buyer’s perspective being that the business has underperformed expectations and the seller’s perspective being that performance expectations have been met or exceeded. The disputes most often relate to a lack of clarity or specificity as to what the performance targets are and how they should be calculated, as well as the level of post-closing support that was required to be provided by the buyer to the acquired business (so that the performance targets could be achieved). Difficulty in crafting and negotiating provisions. Although earnouts are often thought of as a relatively easy, shorthand fix to a major valuation problem, a well-crafted earnout involves numerous inter-related provisions involving the metrics for the earnout formula, the accounting principles that will be applicable to calculation of the Page 4 formula, the process for making the earnout determinations, and the seller’s rights and the buyer’s obligations with respect to the operation of the acquired business during the earnout period. To mitigate the risk of future disputes, these provisions must be drafted with as much clarity and as high a degree of specificity as is practicable. No duty in Delaware to ensure or maximize an earnout. Recent cases have clarified that, in Delaware, there is no duty on the buyer’s part to ensure or to maximize an earnout. The courts have held that a buyer cannot take “affirmative steps” to frustrate an earnout; however, they generally have rejected use of the implied covenant of good faith to “read into” agreements covenants that would obligate a buyer to take, or to refrain from taking, actions to ensure or maximize an earnout. The courts have found a breach of the implied covenant of good faith in the earnout context only in cases in which the buyer took deliberate action to artificially divert revenues from, or expenses to, the acquired business, for purposes of frustrating the earnout. Nonetheless, as is usual in Delaware courts, the overall factual context can be critical, and there is often a high degree of unpredictability as to the result in any given earnout case. Inherent conflict relating to post-closing operation of the acquired business. Importantly, earnouts implicate an inherent conflict between the buyer’s desire to run the acquired business after closing as it sees fit, and the seller’s desire to restrict the buyer’s control over the earnout business as much as possible in order to “protect” the earnout. There is no consistent paradigm for resolution of this conflict; and earnout provisions may favor the seller’s, or the buyer’s, interest in running the business with few restrictions dictated by the other, or may reflect a blending of both parties’ interests. It is not necessarily the case that the seller is in control of the business, with support and limited veto-type rights of the buyer, nor that the buyer is in control of the business, with support obligations and limited veto-type rights of the seller. The negotiation will depend on the facts and circumstances. For example: What is the nature of the business? Can it be kept separate from the buyer’s other businesses? What is the nature of the support the seller will need? What are the expectations of the parties? Are the earnout goals dependent on material expansion? Specificity as to how the earnout business will be run and supported. To reduce the potential for future disputes, parties should evaluate the possibility of being more specific about how the acquired business will be run and what the specific obligations that the buyer (and, if applicable, the seller) will be to support the business. In most earnouts, the parties specify a general standard of efforts that will be applicable to the buyer’s post-closing obligations in connection with running the acquired business—usually some variant of a “good faith” and “all reasonable commercial efforts” standard. The seller will want to ensure that the agreement sets forth as express post-closing obligations of the buyer, at a minimum, all actions that the parties have discussed and expect that the buyer will take that may affect the achievability of the earnout. The buyer’s desire to limit impingements on its discretion in running the business post-closing, and to limit its obligations to provide support to the acquired business, should be balanced with consideration as to the benefits of including certain specified parameters for operation of the business in order to limit the potential for earnout-related disputes. (The law in other jurisdictions varies, with some, such as California and Massachusetts, imposing an implied obligation that a buyer take “reasonable efforts” to achieve an earnout—at least in the absence of an express disclaimer to the contrary.) Need for dispute resolution mechanism. Given the prevalence of earnout-related disputes, parties should not only seek to minimize the likelihood of a dispute but to avoid extensive litigation in the event that there is a dispute (such as by providing for arbitration that will be final and binding on the parties). When the agreement has been clear that the parties have agreed to final and binding arbitration of disputes, the Delaware courts have generally deferred to, and not permitted the parties to challenge, the arbitrator’s determination—even in the face of a result that appeared “unfair” or a process by the arbitrator that appeared to be faulty (absent fraud, manifest error, or non-independence of the arbitrator). Inherent issue of seller’s leverage. As a practical matter, even if there are no issues about the buyer’s post-closing actions, and even if earnout targets are clearly not met, the seller may be able to exert leverage over the buyer to pay some amount of the earnout in order to avoid the expense, distraction and negative publicity about the financial situation of the business that would be associated with a dispute. Earnouts—Practice Points for Avoiding (continues on next page) Earnouts—Practice Points for Avoiding (continued from previous page) Page 5 Earnouts—Practice Points for Avoiding (continued from previous page) Practice Points for Minimizing the Risk of Post-Closing Earnout Disputes Drafting. It cannot be emphasized enough that clarity and specificity of the drafting is the most important factor in seeking to avoid future disputes. Provide hypothetical examples. In the effort to ensure clarity, the parties should consider providing examples in the sale agreement, for illustrative purposes, of how the earnout would be calculated under various hypothetical scenarios. Review by attorneys and accountants early in the process. When practicable, litigators should be engaged early in the process to review earnout-related provisions. Review by accountants can alert the parties to any accounting uncertainties associated with the earnout formula and any issues relating to the process provided for. Further, review by tax and employee benefits lawyers is advisable, as the treatment of items such as tax or employee expenses, accruals, rebates, reserves or other issues often arise and can have a significant dollar impact on an earnout formula. Floor or Cap. The parties should consider including a floor or a cap on the earnout payments, so as to limit the range of discrepancy that can be subject to dispute. Graduated formula rather than all-or-nothing. A graduated formula (i.e., a percentage payment on partial satisfaction of performance targets), as opposed to an all-or-nothing structure (i.e., a single payment, triggered only if performance targets are fully met), may avoid an incentive for the buyer to just miss achievement of the target, or an incentive for the seller to stretch to just make the target (albeit to the detriment on the business), to the extent doing so is within the party’s control. A graduated formula could also reduce the amount of discrepancy that could be subject to dispute. Define the scope of the business upon which the earnout performance targets are based, including any limitations that will apply with respect to certain events counting toward the earnout target (such as any expansion of the business or sales to common customers). Include covenants that will limit possible manipulation of the formula. The parties should consider including covenants that would limit possible manipulation of the formula. For example, if an earnings-based metric is utilized for the earnout target, to prevent the buyer’s manipulation of the result through front-loading expenditures (to the extent it would have the ability to do so), the expenditures that the buyer can make during the earnout period could be limited by specific covenants or could be capped for purposes of the earnout calculation. Specify the accounting treatment of certain items. While GAAP, applied consistent with past practice, is typically the general accounting principle provided for, the parties should consider whether other accounting treatment should be accorded to specific items that are particularly important to the earnout calculation or subject to possible manipulation. For example, specific accounting treatment might be specified with respect to one or more of the following: a cash or accrual revenue basis and the timing of revenue recognition; revenue and expense allocation (including the amount of overhead charged to the acquired business); treatment of uncollected receivables; acquisition expenses and other non-recurring items; revenues or income relating to newly acquired operations and/or common customers; and intercompany transactions or affiliated transactions; amortization of goodwill incurred in the transaction; and the treatment of capital gains, capitalization of expenses, and fixed asset depreciation; whether interest is payable on the buyer’s capital contributions to the acquired business; and whether the effects of purchase accounting, increased capital expenditures, and/or other specified items should be excluded from the earnout calculation. Earnouts—Practice Points for Avoiding (continues on next page) Page 6 Specify the result of certain events. Parties should consider whether the seller may have a right to accelerate payment of the earnout, and/or there would be some other effect, upon the occurrence of certain events, such as a force majeure, a change of control, changes in management, bankruptcy, sale of the acquired business, or other specified contingencies. Include appropriate buyer disclaimer and waiver. To limit the potential for obligations to be imputed to the buyer under the implied covenant of good faith and fair dealing, the buyer will want to disclaim any post-closing obligations other than those expressly set forth in the agreement and may seek to have the seller expressly waive any right to sue under the implied covenant. Other provisions that should be considered: Optional acceleration of payment. The parties could consider including a provision that permits the buyer and/or the seller to elect to accelerate payment of the earnout after a specified period of time (or upon occurrence of a specified event or a specified performance target being reached)—i.e., earlier payment in exchange for eliminating uncertainty going forward. Buyout right. The parties may wish to consider providing the buyer with a right to terminate the seller’s earnout right, for payment of a specified amount, at one or more specified points of time during the earnout period. This right would enable the buyer to “buy its way out of” an earnout dispute (if one appears inevitable) at a pre-arranged price. Similarly, targeted buyout rights could help bridge a difficult negotiation over post-closing covenants. For example, if the buyer is concerned that agreeing to a particular post-closing covenant could become problematic, the parties might agree to a right of the buyer to terminate specific (or all of the) post-closing covenants in the future in return for a specified payment. Putback right. The parties may wish to consider, as a possible route to resolution of a material earnout dispute, the right of one or both parties to elect to have the acquired business sold back to the seller at a specified price. Tailored litigation remedies. A seller should consider seeking to specify remedies for breaches of the sale agreement, as it is typically difficult to prove that earnout benchmarks would have been achieved but for breaches by the buyer. Possible remedies could include liquidated damages; specified adjustments to the metrics of the earnout formula; or payment of all or a specified percentage of the earnout payment. In addition, to deter litigation, the parties should consider providing that the party that does not prevail in the litigation will reimburse the prevailing party for costs and expenses associated with the litigation. Consider possible alternatives to an earnout. Parties should consider whether any alternative would accomplish the objectives of the earnout while mitigating the risk of future disputes. For example: When (as is typical) the seller will be involved in the management of the acquired business, performance-related employee compensation or bonuses may be a preferred mechanism to accomplish the parties’ objectives, rather than an earnout. Milestone payments or contingent value rights (CVRs) might also be considered as an alternative. (CVRs are often tied to a specific non-financial target, such as the outcome of pending litigation or obtaining regulatory approval, and tend to be of shorter duration than earnouts.) Processes for determining earnout and resolving disputes. Importantly, well-crafted, detailed processes for determining the earnout amount and for resolving disputes can minimize the risk of disputes and enhance the likelihood of their being resolved without extensive litigation. Earnouts—Practice Points for Avoiding (continues on next page) Earnouts—Practice Points for Avoiding (continued from previous page) Page 7 Covenants Governing the Post-Closing Operation of the Business Importance of covenants relating to post-closing operation and support of the acquired business. The covenants governing the post-closing operation of the acquired business serve two important functions: (i) to allocate control of the post-closing operations between the buyer and the seller; and (ii) to establish the level of support that the buyer will be obligated to provide to the acquired business. The most common disputes relate to claims that the acquired business was operated by the buyer post-closing in a manner aimed at minimizing the earnout; that the buyer’s investment in and support of the acquired business post-closing was insufficient and caused the earnout targets to be not achievable; and/or that the buyer did not pursue available opportunities that would have increased the earnout. As a general matter, a buyer may want to specify that its only obligation (other than as otherwise expressly set forth in the agreed covenants) is that it will not take affirmative actions with the sole (or, possibly, the primary) purpose of preventing or reducing the earnout payments. A seller may seek to negotiate to include a provision to the effect that the buyer must conduct its businesses following the closing so as to seek to maximize the earnout payments. Importance of specificity. As noted, to reduce the potential for future disputes, parties should be specific and thorough in including covenants that govern how the acquired business will be run, and what obligations the buyer (and, if applicable, the seller) will have to support the business, after the closing. A buyer may seek to bolster the general right to run the business post-closing with an express right to determine specified items in its sole and absolute discretion (e.g., the terms and conditions of any and all relevant sales, including the decision to make or not to make any particular sales and the preference for certain customers over others, irrespective of the effect on the potential of achieving the earnout). A Seller will want to include specific covenants covering any actions that will be important in achieving the earnout targets. Even with respect to actions that have been discussed by the parties, have been acknowledged by the parties as being critical to achieving the earnout, and/or were expected by both parties to be implemented, the seller should not rely on the implied covenant of good faith but should seek to include in the agreement specific covenants requiring that the actions will be taken. The parties should consider including express covenants with respect to the following during the earnout period: capital contributions; adequate capitalization; and dividend policy; hiring or firing of key personnel; employee compensation or pension costs; and appointment or removal of directors; sharing of opportunities; imposing costs on the acquired business that relate to the buyer’s other businesses; and intracompany or affiliate transactions; sales and marketing efforts; size of sales force; rebranding of products; and priority of certain customers over others; restrictions on disposing of all or a portion of the acquired business or other M&A transactions; and R&D expense; technology expense; and other specific expenses. Provide Detailed Processes for Determining the Earnout and Resolving Disputes Provide the parameters for the process to determine the earnout amounts, including who will prepare the initial financial statements and calculations (e.g., the party in control of the business post-closing or an independent accounting firm); what review and/or participation rights the other party will have in the process; how and when those rights may be exercised; and the timetable. Specify a process for resolving disputes. The relevant concerns in drafting a dispute resolution procedure involving arbitration by an independent accounting firm will include: how the firm will be selected; who will pay for the firm; whether the firm is bound by the methodologies provided in the sale agreement (and, if not, what methodologies would be used); Earnouts—Practice Points for Avoiding (continued from previous page) Earnouts—Practice Points for Avoiding (continues on next page) Page 8 whether the firm is limited to considering disputes identified by the parties or can raise other issues; whether the firm is limited to choosing between the parties’ respective results or can do a de novo calculation to derive its own result (and, if a de novo calculation, whether it must be within a specified range based on the parties’ results); what limits there would be on involvement by the parties in the firm’s process; whether the firm’s decision would be final and binding on the parties; the basis (if any) on which a party could bring a claim to dispute the firm’s determination—such as fraud or manifest error (subject to the Federal Arbitration Act (FAA), if applicable); whether a party would be bound by its original earnout estimates (so that those calculations would limit the party’s allowable arguments in any future dispute resolution proceedings); a timetable for the firm’s process; and the timing for payment of amounts not in dispute. Distinguish earnout calculation disputes from other issues. If a post-closing earnout dispute arises, the sale agreement should be carefully analyzed to distinguish and separate from the earnout dispute (i.e., the dispute about the financial accounting relating to the earnout calculation) any issues that are in reality claims of breach of representations and warranties, fraud, indemnification, or other issues. Risk of waiver of objections to arbitrator’s decision when the parties have provided for it to be non-binding. We note that, when the sale agreement provides that an arbitrator’s decision will not be final and binding, each party should be mindful that considerations not reflected in its initial calculations of the earnout, and/or in the initial objections it makes to the arbitrator’s decision, may later be deemed to have been waived and therefore not capable of being raised in future proceedings. Some acquisition agreements require that the buyer and the seller prepare and agree on a written description of the accounting issues in dispute and that the arbitrator limit its decisions to those issues, with the decisions based solely on the arguments and theories raised by the parties. Other considerations. A seller may wish to have the right not only to periodic written reports but also to and/or in-person meetings for earnout-related information; and whether the buyer will be required to grant a security interest in the target company or require the buyer to hold all or some portion of the potential earnout payment in escrow. Basic Structural Terms of the Earnout Selection of metrics. The metrics on which the earnout formula will be based selected should be as straightforward as possible, not easily subject to manipulation, and the best possible reflection of the value of the acquired business in the future to the buyer. Often, the earnout formula with the most compelling rationale is one that is based on the valuation premise utilized in determining the consideration paid at closing—e.g., EBITDA if the buyer valued the business based on a multiple of EBITDA. In lieu of financial metrics, an earnout target may be based on the occurrence (or failure to occur) of one or more specified events (such as the favorable disposition of pending litigation, the obtaining of a patent or regulatory approval, or the launching of a new product). Length of earnout period. Determining the optimal length of an earnout period will involve, for either party, a balancing of many factors. Perhaps most importantly, a longer period will provide a better look into how the business performed, but will also entail a longer period during which there are restrictions on the business and until the earnout has to be paid. Address offset rights; carrybacks; etc. The parties should specify whether there will be any right to use the earnout payments as an offset against any required payments under indemnification claims or otherwise, and whether there will by any adjustment with respect to payments made (or missed) in previous installments based on subsequent performance (e.g., carryback or carry forward of EBITDA from one measurement period to others). A seller may seek to delay other payments being made until the earnout is finally determined. Earnouts—Practice Points for Avoiding (continues on next page) Earnouts—Practice Points for Avoiding (continued from previous page) Page 9 Consider governing jurisdiction law. Parties should take into account the effect on the earnout of the governing jurisdiction for the acquisition agreement. Most importantly, as noted, state laws vary as to the interpretation of the implied covenant of good faith. (By contrast with Delaware, in California and Massachusetts, for example, absent clear language to the contrary in the acquisition agreement, courts have found that, under the implied covenant, the buyer has implied obligations to seek to maximize the seller’s earnout.) In any event, the parties should include specific provisions to effect their intentions, rather than relying on the choice of law provision. In Pell v. Kill and Cogentix Medical (May 19, 2016), the Delaware Court of Chancery, applying an “enhanced scrutiny” standard of review to the defendant directors’ actions, preliminarily enjoined those directors constituting a majority of the board from reducing the board size in advance of a threatened proxy contest led by a director who was in the minority faction. The decision underscores: The risk of legacy-based board factions after a stock-for-stock merger. There is an inherent risk, after a stock-for-stock merger, of dissension, board factions, and ultimately proxy contests, rooted in the directors’ and management’s loyalties based on their legacy allegiances to the respective constituent companies. These potential problems are often triggered by developments which may be outside the control of the resulting company, such as a decline in the stock price or other negative business developments soon after the merger. The issues may be exacerbated when, as frequently occurs (although this was not the case in Cogentix), to assuage the sensitivities of the people involved, a merger that is in fact an acquisition is characterized instead, as much as possible, as a “merger of equals.” These risks should be addressed, and may be significantly mitigated, in the pre-merger planning and structuring, as discussed below. The continued efficacy of the Blasius doctrine (although not as a separate standard of review). The doctrine established by the seminal 1988 Blasius decision by the Court of Chancery—i.e., that directors must have a “compelling justification” for actions that tamper with shareholders’ voting rights—endures. Although no longer viewed by the Delaware Supreme Court as a separate judicial standard of review imposing affirmative obligations on directors, Cogentix reaffirms that the doctrine is to be applied, “within the larger context of … the standard of enhanced scrutiny.” Background Cogentix was formed by a stock merger of Uroplasty, Inc. and Vision-Sciences, Inc. (“VSI”), as a result of which the former Uroplasty stockholders held 62.5% of the Cogentix stock, the legacy Uroplasty directors comprised a majority of the Cogentix classified board, and the Uroplasty management (including the CEO) succeeded to the same positions at Cogentix. Pell, the former CEO and founder of VSI—who was a director of Cogentix, as well as its second largest stockholder and largest creditor—almost immediately after the merger, adopted an antagonistic stance against the Cogentix CEO (Kill). Within a year—and after a stock price drop from $1.75 per share on the date of the merger to $1.03 per share—Pell made it clear that he would commence a proxy contest to change the composition of the board and remove Kill as CEO. Shortly before the annual meeting, at which Pell was seeking the election of his allies as directors, the Kill-aligned faction proposed a reduction in the size of the board (the “Board Reduction Plan”). The Plan contemplated a reduction in the size of the board from eight seats to five, and a reduction in the number of Class I directors from three to one. Without the Plan, the stockholders had the opportunity to elect three nominees to the Class I seats, potentially establishing a new Board majority. Mitigating the Risk of Legacy Board Factions After a Stock Merger—Cogentix Earnouts—Practice Points for Avoiding (continued from previous page) Mitigating the Risk of Legacy Board Factions (continues on next page) Page 10 Mitigating the Risk of Legacy Board Factions (continued from previous page) Mitigating the Risk of Legacy Board Factions (continues on next page) By reducing the number of Class I seats, the defendant directors ensured that no matter how the stockholders voted, they would retain a three-to-two majority for the Kill-aligned faction. The defendant directors intended, after the annual meeting, to increase the size of the board back to eight and to recommend candidates aligned with the Kill-aligned faction. The court assumed for purposes of the opinion that the Kill-aligned directors who supported the Board Reduction Plan were motivated by corporate interests rather than any selfish interest (such as entrenchment). Moreover, the subtext of the opinion seems to indicate that Pell’s opposition to Kill had been inappropriately pursued—and, perhaps, was rooted in his inability to “step back” from the control to which he had been accustomed at VSI before the merger. Nonetheless, the court, applying an enhanced scrutiny standard of review (rather than the deferential business judgment rule) to the directors’ actions—because the directors’ actions related to the election of directors and ”touched on matters of control”— granted Pell’s request for a preliminary injunction blocking implementation of the Board Reduction Plan. Key Point The court explained that, under enhanced scrutiny, even when directors are motivated by what they view as the best interests of the corporation (rather than seeking to entrench themselves based on personal interests), directors cannot take steps to thwart an imminent proxy contest—that is, the board cannot substitute its own judgment for the stockholders’ judgment when it comes to matters that relate to either an election of directors or a vote “touching on matters of control.” The court emphasized that contemporaneous communications indicated that the purpose of the Board Reduction Plan was to thwart the proxy contest and thus maintain the Kill-aligned faction’s board-level control. When “enhanced scrutiny” review applies. The court discussed the three tiers of review for evaluating director decision-making under Delaware law—the business judgment rule, enhanced scrutiny, and entire fairness. Enhanced scrutiny review applies “where the realities of the decisionmaking context can subtly undermine the decisions of even independent and disinterested directors”—that is, where, “[i] nherent in [the] situation are subtle structural and situational conflicts that do not rise to a level sufficient to trigger entire fairness review, but also do not comfortably permit expansive judicial deference” under the business judgment rule. Directors who face a proxy contest confront such a “structural and situational conflict,” the court explained, because “their own seats are at risk” and they “are likely to prefer to be elected rather than defeated,” and so have “a personal interest in the outcome of the election even if the interest is not financial and [the director] seeks to serve from the best motives.” When enhanced scrutiny review applies in the voting context. The court confirmed that the Delaware Supreme Court has indicated that the famous 1988 Blasius decision does not give rise to a separate standard of review. In Blasius, the Court of Chancery held that directors must have a compelling justification for actions that have the effect of restricting the stockholder franchise. In Cogentix, the court, quoting from the Supreme Court’s 2003 Liquid Auto decision), characterized Blasius as “a form of enhanced scrutiny in which the compelling justification concept from [Blasius] is applied within the enhanced scrutiny standard of judicial review.” Enhanced scrutiny applies, the court stated, not only when there is a challenge for outright control of the board, but when “there is director conduct affecting either an election of directors or a vote touching on matters of corporate control.” In this case, the court stated, both reasons existed—the board reduction plan affected an election of directors (because it limited stockholders to voting for one director instead of three) and also touched on matters of control (because it took control of the company “out of play” by preventing the election of three directors who, together with some of the divided incumbents, could have formed a new majority on the board). The parameters of enhanced scrutiny review in the voting context. The court reviewed that enhanced scrutiny, as tailored for reviewing director action that affects stockholder voting, requires that the directors bear the burden of proving: (i) that their motivations were “proper and not selfish”; (ii) that they did not preclude stockholders from exercising their right to vote or coerce them into voting a particular way; and (iii) that the directors’ actions were reasonable in relation to their legitimate objective (i.e., “the fit between means and ends [is] Page 11 Mitigating the Risk of Legacy Board Factions (continues on next page) Mitigating the Risk of Legacy Board Factions (continued from previous page) reasonable”). The court explained that, when the stockholder vote at issue involves an election of directors or “touches on corporate control,” the directors’ justification of their actions must not only be “reasonable” but must be “compelling”— requiring that “the directors establish a closer fit between means and ends.” The shift from “reasonable” to “compelling,” the court wrote, does not imply “strict scrutiny,” but is simply “a reminder for courts to approach directorial interventions that affect the stockholder franchise with ‘gimlet eye.’” Further, the court noted that directors cannot justify their actions by arguing that, “without their intervention, the stockholders would vote erroneously out of ignorance or mistaken belief about what course of action is in their own interests.” The court’s application of “enhanced scrutiny” in this case. Were the directors’ motives in adopting the board reduction plan “proper and not selfish”? At the pleading stage of litigation, the court assumed that they were. Did the directors’ actions preclude the stockholders from exercising their right to vote or coerce them into voting in a particular way? The court viewed it as reasonably probable that the defendant directors would not be able to establish at trial that the Board Reduction Plan would not be preclusive. The Plan made success in a proxy contest “realistically unattainable,” the court stated, because it eliminated the possibility of success for the two seats that it would eliminate. By doing so, the board “imposed its favored outcome on the stockholders: no new directors.” In addition, the court stated, the Plan prevented the stockholders from establishing a new majority, by eliminating the possibility of the stockholders’ electing three Class I directors. By doing this, the board, again, imposed its desired outcome on the stockholders: no change in board-level control. As noted above, the court emphasized that the factual record indicated that the directors approved the Plan to avoid a proxy fight that they feared Pell would win and to preserve board control. Did the directors’ actions bear a sufficiently close relationship to a legitimate objective? The court explained that, even if the Board Reduction Plan were not viewed as preclusive, there remained a reasonable likelihood that the defendant directors would not be able to establish at trial that the plan was “a sufficiently tailored means to an end.” The defendant directors had primarily justified the plan as part of an effort to “rebuild” the board so that it could effectively oversee the company’s business and management for the benefit of all shareholders [by] maximize[ing] a perception of independence… and avoid[ing] persons who are perceived as having too close a tie to management or current directors or specific shareholders….” The court characterized this justification—adopting the plan “so that [the defendant directors], rather than the Company’s stockholders, could determine who would serve on the Board”—as “an unintentional violation of the duty of loyalty.” The belief that “directors know better than stockholders is not a legitimate justification when the question involves who should serve on the board of a Delaware corporation,” the court stated. The defendant directors, secondarily, had justified the plan as creating cost-savings and efficiency given the smaller number of directors. The court, noting that there was no evidence in the record that supported these as objectives of the plan (indeed, we note that they were contradictory to the defendant directors’ stated intention of increasing the size of the board after the annual meeting to “rebuild” it), discounted them as “pre-textual.” Would the outcome have been different if the action had been taken on a “clear day”? The court noted that the “outcome might have been different if the directors had acted before Pell sent [the letter that indicated that a proxy contest was imminent].” Under those circumstances, the court stated, the justifications offered by the defendant directors for the Board Reduction Plan (i.e., cost savings and superior dynamics with a smaller board) “might well have been sufficient.” By acting “in the face of an anticipated proxy contest,” however, their “defensive action compromised the essential role of corporate democracy in maintaining the proper allocation of power between the shareholders and the Board, because that action was taken in the context of a contested election for success directors,” the court concluded. The court’s commentary on the result, if the actions had been taken on a “clear day,” is not entirely clear. Is the court saying that, if a proxy contest were not imminent, then the action taken by definition would not have “touched on corporate control”? Or is the court saying that if a proxy contest were not imminent, and if there was no other evidence establishing or suggesting that the action taken was for a purpose that touched on corporate control, then the justifications offered for reducing the size of the board could have been believable? Page 12 Practice Points Risk of post-merger factions. As occurred in Cogentix, loyalties to the legacy constituent corporations of a merger can create serious issues for the ongoing governance and management of the corporation formed in the merger. The risk is heightened when the controller, former CEO, and/or founder of the smaller of the constituent companies will continue as a director or manager of the merged company—and, particularly when the expectations of those associated with the smaller constituent corporation are unrealistic because the parties (artificially) have strived to characterize the deal as a “merger of equals” when it was in fact one company buying control of the other. The risk is heightened when there is a negative development soon after the merger, such as a stock price decline or negative business-related event. Mechanisms that may mitigate the risk of post-merger factions. Clarity with respect to board composition and associated issues. It is important that the general goodwill and positive expectations by the parties that may be associated with a planned merger not cause the parties to overlook the need to ensure that their intentions on matters relating to composition of the board are fully considered and accurately reflected in the drafting—particularly if there is a likelihood of post-merger issues arising. While the merger agreement drafting was not addressed by the court in Cogentix, we note that, if it is likely that board-related issues may arise post-closing, it is critical that the parties consider, and accurately reflect in the merger agreement and the charter and bylaws of the resulting company of the merger, their intentions with respect to size of the board; changes in size of the board; director nominations; composition of the nominating committee; removal of directors; annual meeting procedures; and related provisions. Supermajority board vote requirements. Depending on the composition of the post-merger board, the parties should consider whether the taking of specified actions (for example, changes in the size of the board or changes in the size or leadership of the nominating committee) should require a supermajority vote of directors. Supermajority requirements have been unusual except in “merger of equals” transactions. Again, consideration would be prudent particularly if the circumstances indicate that there are likely to be post-merger issues regarding control (for example, if the parties already have clashed on the issue of who will running the company). Structure of board representation. The larger constituent party may wish to seek to structure the board arrangements to try to minimize the possibility of a change of control challenge until, at least, after the first annual meeting of the surviving corporation. In this connection, the larger constituent party may seek to provide less than pro rata board representation for the smaller constituent party, and/or may seek to place, to the extent possible, the smaller constituent party’s representatives in the class of directors up for election at the first meeting, if the resulting company has a classified board. Standstills. It may be appropriate to seek standstill-type provisions that would keep in place, for a limited period of time, the initial arrangements relating to composition of the board (in order to avoid a proxy contest for, say, a year or two). Stock buy-back right. The larger constituent party should consider seeking to have the right to buy back the surviving corporation stock held by a principal stockholder of the smaller constituent party. In addition, the principal stockholder should be required to resign from the board if his or her ownership drops below a specified percentage. “Buy-in” to plans. Parties should discuss and try to reach a general understanding as to the direction of the combined company, including with respect to plans that are either critical to the post-merger company or likely to engender disagreement at the board level (although it would not be feasible to bind a board to a specific business plan). Mitigating the Risk of Legacy Board Factions (continued from previous page) Mitigating the Risk of Legacy Board Factions (continues on next page) Page 13 Email evidence. As we have emphasized in numerous other articles, boards must recognize that emails and other contemporaneous communications can and will be used as evidence in the event of litigation challenging their actions. In Cogentix, the court noted that the directors’ contemporaneous communications referred explicitly to their views that it was critical for them to maintain control of the board and to avoid a proxy contest. Even with the court assuming that the defendant directors’ motivations were based on the best interests of the company (i.e., that the motivation was to preserve control in order to be able to rebuild the board after the annual meeting with candidates that the defendant directors would carefully identify, vet and select, rather than their accepting potentially less qualified and/or more partisan nominees), these communications indicated to the court that the defendant directors had sought to substitute their judgment for that of the stockholders (which, as the court stated, “Delaware law does not permit”). Influence of debt positions. Although apparently not a major factor in the result in Cogentix, we note that the situation serves as a reminder that large debt-holdings by a director, stockholder or officer can augment his or her post-merger influence. Pre-merger planning should take into consideration not only the equity holdings of the various directors and officers, but their debt holdings as well—particularly in the case of highly leveraged companies that may face possible debt covenant breaches or bankruptcy without the forbearance of a major debt-holder. Mitigating the Risk of Legacy Board Factions (continued from previous page) The Changing Game Theory of Delaware Appraisal— Impact of Recent Amendments to the Delaware Statute and the Dell Decision The Changing Game Theory (continues on next page) Statutory Amendments The following amendments to the Delaware appraisal statute were signed into law on June 16, 2016, and will be effective with respect to appraisal proceedings arising out of transactions consummated pursuant to agreements entered into on or after August 1, 2016: The “Interest Reduction Amendment.” Companies will now have the option to pay a cash amount to the dissenting stockholders before the appraisal proceeding ends (an “Upfront Payment”) in order to reduce the statutory interest that would be payable when the appraisal award decision ultimately is made. After an Upfront Payment is made, statutory interest would accrue only on the unpaid portion of the ultimate appraisal award. The Upfront Payment would be non-refundable, as there is no claw-back mechanism provided for a company to recoup any amount paid that turns out to have exceeded the appraisal award. The “De Minimis Amendment.” There will now be a de minimis exception to appraisal rights. Appraisal petitions will be dismissed if the shares seeking appraisal were traded on a national securities exchange and (a) the value of the merger consideration applicable to the shares seeking appraisal is $1 million or less, or (b) the shares seeking appraisal represent 1% or less of the total outstanding shares of the class entitled to appraisal rights. The threshold minimums will not apply in the case of appraisal following a short-form merger (since appraisal may be the only remedy available to dissenting shareholders in a merger in which there is no stockholder vote). Background There has been a concern that a significant portion of appraisal petitions are motivated primarily or even exclusively by the interest factor itself (so-called “interest arbitrage”). The statute requires that companies pay interest on an appraisal award at a rate equal to 5% above the Federal Reserve funds rate, compounded quarterly, accruing from the effective date of the merger to the date of payment of the appraisal award after conclusion of the appraisal proceeding. The Page 14 The Changing Game Theory (continued from previous page) statutory interest rate is significantly above the regular interest rate payable on deposited funds. Indeed, the interest on an appraisal award can itself represent a significant additional premium above the merger price and undoubtedly has been a factor in the calculus relating to the bringing and settlement of appraisal claims. The interest factor has been viewed as encouraging appraisal petitions by (i) guaranteeing a perceived above-market return during the substantial period before an appraisal award is determined and received, (ii) cushioning against the risk of an ultimate appraisal determination that is below the merger price, and (iii) funding a reimbursement of the costs of the appraisal proceeding. Notably, the statutory rate in appraisal cases is the same rate as applies in other Delaware litigations. The Chancery Court (in the 2013 CKx decision that was upheld by the Delaware Supreme Court and that this amendment overrides) acknowledged that the risk of “rent-seeking” is higher in appraisal cases than in at-fault litigation, and noted that the purpose of the interest on an appraisal award is not to provide a market rate of return on cash (i.e., conventional interest) but to compensate for the loss of a return that could have been obtained by having had the funds available to invest, as well as the credit risk associated with appraisal litigation. In any event, in our experience, the primary motivation behind “strong” appraisal claims is the potential for a “bonanza”- type appraisal award. The interest awards in these cases are large simply because the appraisal award itself is large. We note that the high interest provided by the statute is still significantly below the target rate of return for hedge funds, which tend to be the most frequent appraisal arbitrageurs (i.e., parties that view appraisal claims as an investment, buying shares after announcement of a merger for the purpose of making an appraisal claim). The Legislature’s March 2015 white paper, released in connection with the amendments when proposed, when rejecting a reduction in the statutory interest rate, stated that there is no empirical evidence suggesting that interest arbitrage is prevalent. Likely effects of the statutory amendments Uncertainty as to consequences. There is considerable uncertainty in general as to how companies and petitioners will respond to the Amendments and what the practical impact on appraisal will be. Additional flexibility for companies in appraisal proceedings. The Interest Reduction Amendment provides companies with the right to decide whether, when, and in what amount to make an Upfront Payment. While the Amendment does not benefit companies as directly and fully as has been advocated by companies (i.e., by lowering the interest rate itself or eliminating appraisal with respect to shares acquired after announcement of a merger), the added flexibility for companies afforded by the Amendment should advantage companies in the appraisal process, as they will have the option either to maintain the status quo or, if it would appear to be of benefit, to make an Upfront Payment. Likely to reduce the volume of “weak” appraisal claims. We think it likely that the volume of “weak” appraisal claims will be reduced as a result of the proposed Amendments. (By “weak” claims, we mean those that are made with respect to transactions that are not likely to result in an appraisal award that is significantly higher than the merger price. In our ongoing survey of appraisal decisions since 2010, we have found that the Chancery Court has tended not to award appraisal amounts significantly exceeding the merger price in cases involving a third party arm’s length transaction and a robust sale process.) Until now, “weak” claims could be made simply based on settlement value, calculated in large part as the present value of the merger price plus the statutory interest. Settled relatively quickly, the focus of these claims is often the additional amount provided by the interest factor. We expect that, going forward, in these situations a company generally would make a large Upfront Payment (representing a significant percentage of the merger price), effectively eliminating the economic value of a weak appraisal claim. In addition, the De Minimis Amendment should reduce weak claims as it will exclude cases that do not attract much interest from potential dissenting stockholders. Not likely to reduce the volume of “strong” appraisal claims. In our view, it is likely that “strong” appraisal claims would continue to be made at the same rate as currently. (By “strong” claims, we mean those that are made with respect to transactions that are likely to result in an appraisal award that is significantly higher than the merger price. In our survey, we have found that the Chancery Court awarded appraisal amounts significantly exceeding the merger price The Changing Game Theory (continues on next page) Page 15 The Changing Game Theory (continued from previous page) only in cases involving an interested party transaction and a sale process that the court regarded as not having been robust.) The primary motivation for stronger claims is the potential for an appraisal award significantly higher than the merger price, not the interest factor (with the large interest amount simply being a corollary of the large appraisal award). May marginally reduce the volume of “marginal” appraisal claims. Based on the reasoning above, with respect to appraisal claims that are neither clearly “weak” nor clearly “strong,” the Amendments may reduce the volume of claims that are toward the weaker end of the spectrum. May encourage more dissenting shares to be included in cases of “strong” appraisal claims. Upfront Payments in appraisal cases would significantly reduce the risks for petitioners associated with bringing appraisal petitions. An Upfront Payment representing a large percentage of the merger price would result in petitioners having only limited capital at stake during the proceeding (providing an opportunity for a highly-leveraged yet low-risk investment with the potential for outsized returns on the limited capital invested); having only a minimal credit risk during that time; and being able to use the Upfront Payment from the outset to fund the costs of proceeding. Thus, while strong cases would be brought anyway (as noted above), if companies develop a practice of making Upfront Payments that represent a large percentage of the merger price, then we expect that a larger number of dissenting shares may be included in cases with strong claims. May make settlement of “strong” appraisal claims more difficult. Currently, companies have an incentive to settle to avoid continued accrual of the above-market statutory interest payable to the petitioners; and petitioners have an incentive to settle to reduce the time they have to wait for a payment from the company. The larger the Upfront Payment made by the company, the more these incentives would be reduced, potentially making settlement more difficult and unlikely. Game theory of Upfront Payments A company’s decision whether, when, and in what amount to make an Upfront Payment will be complicated. Factors to be considered. An evaluation of numerous factors will have to be made. Economic benefit of reducing interest cost. A company will need to determine the economic benefit of reducing the amount on which the statutory interest will have to be made, as compared to the economic benefit of holding all of the funds for the full period of the appraisal proceeding (based on the company’s cost of capital, access to capital, need for cash, and other factors); Strategic disadvantage. A company will have to consider the strategic disadvantage to the company of providing a significant cash payment to the dissenting stockholders before the end of the appraisal proceeding that will reduce their capital at stake and credit risk and that could be used to fund their expenses; and Avoiding an overpayment. A company will need to take into account the degree of confidence it has, and at what stage of the proceeding it has it, as to what the likely range of the ultimate appraisal award will be—so that the company does not pay more in the Upfront Payment than the amount ultimately awarded (since, as noted, any excess amount will be forfeited). When companies may be unlikely to make an Upfront Payment. A company may be unlikely to make an Upfront Payment if its cost of debt is equal to or greater than the statutory interest rate; if the company is a credit risk; or if the company believes the payment would significantly facilitate or favor the petitioners’ case or make reaching a settlement more difficult. “Weak” appraisal claims—companies may be likely to make an Upfront Payment. As noted above, in the event of a weak appraisal claim, we expect that, to reduce the interest cost and thus to eliminate the basis for the economic value of the claim, most companies generally would opt to make a large Upfront Payment. The Changing Game Theory (continues on next page) Page 16 The Changing Game Theory (continues on next page) “Strong” appraisal claims—more difficult calculus as to whether to make an Upfront Payment. In the case of a strong appraisal claim, the balance of the advantages and disadvantages of making an Upfront Payment will be more complicated. Although there is an intuitive logic to a company’s making a large Upfront Payment to reduce the large interest cost, it may be that companies will make only a relatively small Upfront Payment in order to achieve some modest reduction in interest cost, while preserving leverage going forward with respect to settlement by not reducing as much the petitioners’ capital investment and risk. The decision as to the size of the Upfront Payment would, of course, be affected by whether more than one Upfront Payment can be made during an appraisal proceeding (see below). Timing of Upfront Payments Deadline for filing of petitions. Presumably a company would not want to make an Upfront Payment until after the deadline has passed for petitions to be filed—i.e., 120 days after the merger effective date. Determining amount of large Upfront Payment. Since, as noted, any amount of the Upfront Payment that exceeds the amount ultimately awarded will presumably be forfeited, ideally a company wanting to make a large Upfront Payment would want the payment to be as close to the ultimate appraisal award as possible without exceeding it—not necessarily an easy exercise. Use of merger price as a guide for the amount of an Upfront Payment. In the hypothetical example provided in the white paper discussing the Amendments when they were proposed, the company made an Upfront Payment equal to 75% of the merger price. While this may prove to be a reasonable guide, uncertainty arises because the court still does not rely on the merger price in all cases in determining appraised “fair value,” and often relies instead on discounted cash flow and comparables financial analyses, the results of which can (and often do) vary significantly from the merger price. In addition, the appraisal statute mandates that value arising from the merger itself be excluded from appraised fair value—thus requiring that factors such as expected merger synergies (and possibly a control premium) that are embedded in a merger price be “backed out.” To date, the court has not provided much guidance on the complex issues that arise in connection with these types of adjustments; thus, uncertainty arises from the potential that adjustments will be made and, if made, from the lack of clarity as to how they will be made. Petitioners’ fair value argument. A company would not want to prejudice its argument in the proceeding by making an Upfront Payment that exceeds the amount it is arguing represents fair value (even if the company believes that the appraisal award may significantly exceed that amount). The Synopsis of the amendements, provided by the Delaware State Bar Association, states: “There is no requirement or inference that the [Upfront Payment] … is equal to, greater than, or less than the fair value of the shares to be appraised.” We note, however, that, as a practical matter, the court may to some extent be influenced by a company’s determination of what is an appropriate Upfront Payment amount. Unanswered questions The following questions are not addressed in the Amendments, although the answers could be important in the game theory analysis by companies and petitioners: Can “overpayments” be recouped? As noted, we presume that any excess of the Upfront Payment amount over the ultimate appraisal award amount will not be recoverable by the company (as no claw-back mechanism is provided). However, it is unclear whether a company could condition its making an Upfront Payment on later recovering any amount that is in excess of the ultimate appraisal award. Can multiple Upfront Payments be made? Presumably, the objective of the Amendment would best be served by permitting multiple payments in order to maximize the total Upfront Payment amount and to permit a company to make payments on a more informed basis as the proceeding progresses. It is unclear whether a company could condition its making an Upfront Payment on a right to made additional Upfront Payments. The Changing Game Theory (continued from previous page) Page 17 The Changing Game Theory (continued from previous page) Can different Upfront Payments be made to different petitioners? The Amendment is clear that, if an Upfront Payment is made, it must be made to “each stockholder entitled to appraisal” (not including any stockholder whose qualification for appraisal is being challenged), but it is not clear whether different amounts can be paid to different stockholders. Companies can enter into settlements with individual petitioners, but it is not certain whether the Upfront Payments could be used to encourage settlement by providing lower amounts to petitioners who are perceived by the company as being more sensitive to the tie-up of their capital for the appraisal period. Changes not made. The Amendments do not include any of the more far-reaching changes that have been advocated by companies and others seeking to limit the volume of appraisal claims and the prevalence of appraisal arbitrage, or to ameliorate the burden on the court of determining “fair value,” such as: a limitation on the types of transactions to which appraisal rights would be applicable; restrictions on the timing for filing an appraisal petition; a change in the definition of fair value; limiting appraisal rights to stockholders who owned their shares before announcement of the merger; further requirements with respect to establishing that shares have not been voted in favor of the merger; or establishing a burden of proof on the parties (rather than the Chancery Court) to determine fair value. In addition, as noted, the Amendments do not reduce the statutory interest rate itself. Dell Decision In Appraisal of Dell Inc. (May 31, 2016), the Court of Chancery awarded an appraisal amount that was 30 percent higher than the price that was paid in the $25 billion merger in which Michael Dell (the founder, CEO and 16% stockholder of Dell) and private equity firm Silver Lake Partners took Dell private. In the merger, Mr. Dell, having rolled over his equity and invested $750 million of cash, obtained 75% ownership of the company. The court utilized a discounted cash flow (DCF) analysis to appraise Dell’s “fair value” for appraisal purposes (i.e., the going concern value of Dell at the time of the merger, excluding the value of any expected synergies), having concluded that, in this case, the merger price was not a reliable indicator of fair value. Background. In the presigning phase, Mr. Dell discussed a potential going-private transaction with Silver Lake and another financial buyer, and the special committee contacted one financial buyer, but Silver Lake was the only bidder. In the post-signing go-shop phase, numerous financial buyers were contacted. No strategic buyers were solicited, as the committee believed that they would not be interested (primarily because of Dell’s very large size and complexity). Carl Icahn made a topping bid, which caused Michael Dell/Silver Lake to raise their price by 2%—but the ultimate merger price was still slightly below Icahn’s bid. While the merger price represented a substantial premium over the unaffected Dell stock trading price, the company’s proxy statement reflected that Mr. Dell and the company’s financial advisers viewed the company’s value as being significantly higher. Nearly half of the stockholders dissented from the merger and sought appraisal rights (although, in a separate litigation, the court ruled that, for most of the dissenting shares, appraisal rights had not been perfected properly and thus had been forfeited. We use the terms “LBO” and “MBO” in this article as follows: LBO (“leveraged buyout”)— A transaction with a financial buyer that includes no management buyout component or a nonsignificant management buyout component. MBO (“management buyout”)— A transaction with a financial buyer that includes a significant management buyout component. Whether the court will regard a transaction with a management buyout component as an LBO or an MBO will depend on the facts and circumstances, particularly the extent to which the target and/or the transaction is viewed as dominated by the target’s managers who are participating in it.) The Changing Game Theory (continues on next page) Page 18 Key Points In our view, Dell is consistent with the court’s recent approach in appraisal cases—and underscores that the court will base appraised “fair value” on the merger price only when the court believes that the merger price is the best indicator of fair value. Historically, the court has relied primarily on the discounted cash flow (DCF) methodology to determine appraised “fair value.” In a few recent cases, the court has relied instead on the merger price when the court has determined that it was the best indicator of fair value. Importantly, in these recent cases, there was a presigning public auction sale process; in most of them, the court, in addition, regarded the inputs available for a DCF analysis to be unreliable; and none of them involved an MBO. Some commentators have regarded Dell as a departure from the court’s reliance on the merger price in these recent cases. In our view, Dell is consistent with the court’s recent approach—i.e., relying on the merger price when the court has determined that, by virtue of the process through which the merger price was determined, it provides the best indication of appraised fair value. The court regarded the Dell sale process as well-crafted for fiduciary duty purposes—but, for appraisal purposes, as insufficient to outweigh the factors that undermined the reliability of the merger price as an indicator of “fair value.” The court found that the Dell sale process, as a process matter, “easily” passed muster for fiduciary duty purposes—but that, because the process “lacked meaningful competition,” it was not sufficient for the court to determine that the price derived through it reflected “fair value” for appraisal purposes. The decision serves as a reminder that the extent to which the court will view a sale process as having been sufficiently competitive to establish that the merger price is the best indicator of appraised fair value will depend on the facts and circumstances—and that the court will take into account its view of the underlying reality of the sale process based on real-world factors. The decision highlights the appraisal risk in MBOs. The opinion reflects that the courts generally are skeptical that the merger price in an MBO is a reliable indicator of “fair value” for appraisal purposes. Due to a number of features present in Dell (not all of which are always present in MBOs), that skepticism was heightened. Contrary to recent commentary on the decision, in our view the court’s discussion of the “LBO pricing model” does not mean that the court will not rely on the merger price to determine fair value in any merger with a financial buyer. In our view, the court’s discussion indicates that a buyer’s use of an “LBO pricing model” will be one factor taken into account in evaluating whether the merger price is the best indicator of appraised fair value—and we expect that it would be unlikely to ever be a significant factor where, on the one hand, a truly competitive market check has taken place or where, on the other hand, the transaction involves an MBO. We note that most of the recent cases in which the court did view the merger price as the most reliable evidence of fair value involved LBOs. Conclusion In our view, the Amendments, and the courts’ recent increased reliance on the merger price in determining fair value, will not significantly discourage appraisal overall so much as they will further drive activity toward stronger appraisal claims— i.e., claims involving transactions that represent a high potential for awards significantly exceeding the merger price. As we have discussed in previous Fried Frank M&A Briefings, these “stronger” appraisal claims involve interested party transactions without a robust sale process (reflecting the Chancery Court’s skepticism that the merger price represents fair value in these transactions) or transactions involving a company with a dominant shareholder or an MBO. It remains to be seen how often interested party transactions will now be structured to meet the MFW process prescriptions for business judgment rule review in fiduciary duty litigation and to what extent the court may determine to expand its reliance on the merger price when there is a robust sale process that is short of a pre-signing auction. The Changing Game Theory (continued from previous page) Page 19 In CDX Holdings v. Fox (June 6, 2016), the Delaware Supreme Court upheld a Court of Chancery ruling (July 28, 2015) that the Caris Life Sciences board had not made a good faith determination of the fair market value of shares that were the subject of stock options that were being cancelled in connection with a spin-off/merger transaction. The underlying transaction involved a sale of a subsidiary of Caris to Miraca Holdings in order to secure financing for two of Caris’ other subsidiaries. To minimize the tax consequences of the sale to Miraca, the transaction was structured to combine the other two subsidiaries and spin off the resulting company to Caris’ stockholders, followed by a merger of Caris with Miraca in which the Caris stockholders received $725 million in cash. The founder of Caris and an investment fund owned a total of more than 97% of Caris’ stock, and most of the remaining 3% consisted of stock options that were cancelled in connection with the Miraca merger. The plan under which the options had been issued provided that each stock option holder had the right to receive, for each covered share, the amount by which the fair market value of the share exceeded the option exercise price. The plan required that, if the options were cancelled, the Caris board would use good faith to determine and properly adjust the options to account for the fair market value of the spinco. The plan provided that the board’s determination of fair market value would be final and binding on the parties, unless the determination was “arbitrary and capricious.” Caris determined that the spun-off entities had a value of $65 million and that the option holders were entitled to $0.61 per option. The Court of Chancery found that: The Caris board never made the required fair market value determination; The Caris CFO/COO made the determination, and the CEO perfunctorily signed off on it; and The determinations by the CFO/COO and CEO were not made in good faith, but through an arbitrary and capricious process. Vice Chancellor Laster concluded that “the number [the CFO/COO] picked for SpinCo was not a good faith determination of Fair Market Value. It was the figure generated by … the Company’s tax advisor, using an intercompany tax transfer analysis that was designed to ensure that the spinoff would result in zero corporate level tax.” Although the Court of Chancery commented at the conclusion of the trial that “a tax-style intellectual property valuation… [and] [t]he standard of fair market value may be the same,… when valuation professionals approach these things, they do things with different mindsets.” The court found for the plaintiffs and awarded damages of an additional $16.3 million to the option holders for their interest. After the ruling, it became clear that, absent a computational error made by the court, the damages would have been $24 million, and the parties agreed to that amount in settlement. The Supreme Court deferred to the Court of Chancery’s factual findings, noting that, after a trial, the Court of Chancery’s findings of historical fact (whether based on credibility determinations, physical or documentary evidence, or inferences from other facts) are subject to a “clearly erroneous” standard of review. Justice Valihura dissented, contending that the board had delegated to the CFO and, on the advice of legal counsel, to an independent advisor, “the complex computational task” of determining the fair market value of the spinco and the resulting required adjustment to the options—and that the board was entitled to rely on its advisors in making the determination. Justice Valihura also concluded that the Chancery Court was wrong in making no findings with respect to the Caris board having acted in bad faith and finding instead that the Caris board had not “acted” at all. The board had acted to determine fair market value, according to the Justice, by meeting with legal counsel and engaging an independent advisor to assist the board; meeting with its financial advisor and reviewing the advisor’s valuation analysis; and adopting a resolution of the board. Delaware Supreme Court Upholds Decision on MisValuation of Cancelled Stock Options—CDX Delaware Supreme Court Upholds Decision (continues on next page) Page 20 Delaware Supreme Court Upholds Decision (continued from previous page) The Justice was also critical of the Chancery Court’s finding that the Caris directors’ testimony was not credible. She observed that the Chancery Court had initially found that the directors had “testified with conviction” and that their credibility was “very, very strong” with respect to their having believed that the spun-off entities had very little value. She criticized the Court of Chancery for having then resolved the discrepancy between that testimony, on the one hand, and contemporaneous evidence that indicated that the spun-off entities had significant value, on the other hand, by relying on what the Court of chancery had referred to as the “hindsight bias” theory discussed in “the psychological literature” (and defined as a “tendency for people with outcome knowledge to believe falsely that they would have predicted the reported outcome of an event”). Justice Valihura wrote: “In my view, this Court should be skeptical of court rulings predicated upon social science studies, particularly where, as here, such theories impact a trial court’s own post-trial impressions of the testimony offered.” Critical factors. The stock option plan that governed the board’s contractual obligations to the option holders provided the board with broad discretion to determine what the option holders would receive in a merger and also provided that the board’s determination would be final and binding. However, the Court of Chancery’s conclusions, and the Supreme Court’s affirmance, were made in the context of the following critical factors—the absence of any one or more of which, in our view, could well have led to a different result: The CEO and CFO acknowledged that they had “engaged in fraud” with respect to Miraca, by creating projections that were “a fantasy land” and should not now be believed; There was contemporaneous evidence that the CFO, who provided information to the tax advisor to support a $65 million valuation of the spinco (which was the number used by the board) had “subjectively believed” just a few months earlier that the fair market value of the spinco was $150-300 million (and that Caris’ financial advisor, CEO, Miraca’s tax advisor, and others viewed the $150-300 million valuation as correct); The firm engaged to provide a second opinion on the fair market value determination had provided the same determination of fair market value that the tax advisor had, although using materially different inputs—and, according to the court, had conceded that it had “largely…copied [the tax advisor]’s analysis”; There was evidence that certain directors were not even aware of the stock option plan or its requirements; and The CEO, who “perfunctorily approved” the tax advisor’s fair market value determination, was a controller (i.e., the founder, CEO, and 70% stockholder of Caris). Practice Points Board’s contractual obligations. With respect to any contractual obligations of a board (such as under a stock option plan), the board should, based upon advice of counsel: Be aware of the obligation and specifically what is required; Take all of the required actions; Document that it has taken all of the required actions--mirroring the language from the applicable agreement; and Understand the financial analyses performed by the advisors, whether the analyses were unusual, and how the analyses differed (if at all) from “standard” analyses. In Caris, the board received a presentation regarding the advisor’s determination of fair market value and passed a resolution confirming that all action required under the stock plan would be taken prior to the merger. However, the board did not document that it had determined fair market value and what that determination was. Moreover, the tax advisor should have labeled its materials to indicate that the analysis was a fair market value analysis (not just a tax-based analysis). Financial firm’s performance. CDX is a reminder of the potential for damages and/or ordered injunctive relief based in part on a financial firm’s failure to perform its role appropriately. The Court of Chancery opinion also served as a reminder Delaware Supreme Court Upholds Decision (continues on next page) Page 21 of the reputational risk resulting from poor performance, with Vice Chancellor Laster having characterized the valuation firm’s work as “a new low.” Among other things, the Court of Chancery found that the valuation firm: simply copied the tax advisor’s report, as evidenced by the fact that the results matched even though the inputs to the analyses were different; did not perform a comparable companies analysis even though, in stock option valuation reports just months earlier for other purposes, it had deemed another transaction (which would have implied a significantly higher valuation and frustrated the tax-free spin-off analysis) to have been comparable; used “the cost method” of analysis and rejected discounted cash flow and comparables analyses because, it contended, management’s projections were unreliable, even though it had relied on those projections, and had used DCF and comparables analyses, in all of its prior valuations for the company for other purposes; and made numerous “significant errors,” including mistakenly using a company’s trailing nine-month revenue for 2010 instead of projected twelve-month revenue for 2011, and, by basing its fair market value analysis on the tax advisor’s work that was intended to determine intercompany transfer tax liability, wrongly excluded certain assets, including goodwill. Delaware Supreme Court Upholds Decision (continued from previous page) This article is excerpted from a recent Fried Frank M&A Briefing, The Urge to Merge in a World of Heightened Regulatory Risk (April 23, 2016), available on the Fried Frank website, and previously published by Law360 and by the Harvard Law School Forum on Corporate Governance and Financial Regulation. As U.S. corporations face the later stages of a prolonged economic recovery, with the prospect of slow growth, a number of strategies have been considered to meet the challenge of producing meaningful profit improvement in a short timeframe—with corporations increasingly turning to tax inversion transactions (for the dramatic and immediate reduction of tax expense) and mergers (for the significant expected synergies). At the same time, the U.S. government has evidenced rising skepticism toward inversions and mega-mergers. In a recent Fried Frank M&A Briefing, we noted the challenge of heightened regulatory risk for deals; offered critical points for early planning to optimize the timetable for obtaining approvals; and discussed the recent harder line approach by the U.S. (and non-U.S.) antitrust regulators with respect to the approval of divestiture packages proposed by merger parties. Below, we discuss a variety of tools that can be considered by merger parties to craft remedies to antitrust concerns and to allocate the risk between the parties as to the possibility of approvals not being obtained. Parties are advantaged by being strategic in their selection among these tools and in creatively tailoring them in novel ways to meet the challenges of the specific deal at issue. Crafting Divestiture Packages Integrated package approach. Regulators will be less likely to approve a divestiture package that is comprised of a diverse assortment of assets than a package that is presented as a stand-alone business or as part of an integrated plan that will enable the assets to be pro-competitive after divestiture. Thus, in transactions that present significant antitrust concerns, it should be taken into consideration early in the parties’ planning that, for the proposed divestiture package to be viewed by the regulators as likely to be pro-competitive, it may become necessary to include assets that the acquirer would prefer to retain. Whether these assets should be included in the initial proposed package, or only if necessary later in the process, will depend in large part on an analysis of how likely it is that they ultimately will have to be included and the merger parties’ view of the importance of obtaining approval sooner rather than later. Practical Points on Antitrust Planning, Divestiture Packages, and Reverse Termination Fees Practical Points on Antitrust Planning (continues on next page) Page 22 Suitable buyer—consider types of support for divested assets. A suitable buyer will typically be one with the experience, infrastructure, and financial wherewithal to be a strong competitor in the relevant market. If, as is often the case, the only potential buyers of the assets to be divested are not likely to be “suitable buyers” who will be able to support and develop the assets, short-term support agreements may be required by the regulators as an additional condition to approval. The government’s emphasis in recent years has been on support that will permit the buyer of the divested assets to become a completely independent strong competitor as quickly as possible. Support agreements can be creatively tailored to the specific circumstances. As one example, in a situation in which our client placed a very high priority on a proposed merger and it was clear that there were very few potential buyers for the assets that might be deemed to be “suitable,” we crafted a support arrangement where, over a period of time, a development fund with a fixed dollar amount, established by our client and administered by the regulator, was available for expansion purposes upon the request of the divestiture buyer. While financing of a divestiture buyer is disfavored by the regulators, under the specific circumstances applicable in that case, the escrow of the funds—with no strings attached, the money placed in a fund administered by the regulator, and the buyer able to access the money at any time and without restrictions (other than that it had to be used for a specific type of expansion in a specific area)— was viewed by the regulators as ensuring that the buyer would be an effective competitor. Consider spin-off of divested assets. A merger party could also consider whether, in lieu of divesting assets to a buyer, the assets could be divested in a spin-off. A spin-off could offer the advantages that a suitable buyer would not have to be found and that the arrangements are self-executing (i.e., the company determines the arrangements without having to negotiate with a third party). Perhaps most importantly, all of the value delivered to the spinco would be captured by the merger party’s stockholders (rather than by a third party, in what is often the equivalent of a “fire sale” due to the pressure to divest to obtain the approvals). We note that spin-offs have rarely been used for required antitrust divestitures. First, as a business matter, depending on the circumstances of the specific situation, creating a strong competitor through a spinoff may not be the preferred option when there are other acceptable alternatives. (Note that the spin-off in this context would not involve the typical arrangements that favor the company and disfavor the spinco; rather, the arrangements would have to ensure that the spinco would be a viable stand-alone entity and a strong competitor. A spinco would have to have sufficient assets transferred to it, adequate capitalization, a strong management team, and so on.) Second, the regulatory agencies would have to be satisfied as to the viability and independence of the spinco, as well as issues relating to completion risk and timing of the spin-off, including any required stockholder or third party approvals and SEC review. (We note that the spinoff alternative is unlikely to be acceptable to the regulators where there is concentrated ownership of the divesting company, due to issues relating to overlapping ownership with the spinco.) However, in our view, under appropriate circumstances, a spin-off may be an effective option for meeting business objectives (indeed, the availability of a viable spin-off alternative should increase the company’s negotiating leverage with potential third party buyers of the assets to be divested); and, if properly crafted and presented, a spin-off may be acceptable to the regulatory agencies. Note. With respect to all of the approaches described above, we note that, in the current enforcement environment, pursuing creative remedies will take strong advocacy and a convincing showing that the proposed solution will effectively preserve competition in the relevant markets. Reverse Termination Fees The risk of not ultimately obtaining antitrust approval is sometimes (often, in antitrust-sensitive deals) dealt with through a “reverse termination fee”—i.e., a fee paid by the acquirer to the target company (or, in a private deal, the sellers) if antitrust approvals are not obtained by the drop dead date. The premise of an RTF is that it (i) provides a financial incentive to the buyer to take the necessary steps with respect to divestitures or other solutions to satisfy the concerns of the antitrust regulators so that the deal can proceed and (ii) provides the seller with compensation if the regulators’ antitrust concerns cannot be satisfied and the deal cannot proceed. RTFs tend to be negotiated based on the specific facts and circumstances Practical Points on Antitrust Planning (continued from previous page) Practical Points on Antitrust Planning (continues on next page) Page 23 of individual deals—with RTFs used most frequently, and tending to be larger amounts, in those deals in which the antitrust risk is perceived to be greatest and where the target company (or seller) has reasonable negotiating leverage. A higher RTF might also be used as part of inducing a target company to agree to more restrictive interim covenants on the target’s operations pending closing or to a more distant drop dead date. RTFs are also used in transactions that face other types of regulatory issues—including, in inversion transactions, changes in the expected tax treatment. RTFs are not subject to the same type of fiduciary duty issues as deal protection breakup fees, and a successful fiduciary challenge to an RTF would be unlikely. The size of RTFs has not been limited to the typical 3-4% range of deal protection fees. A Practical Law study released in May 2016 indicates that, of 112 public and private deals (with respect to the public deals, announced from November 2012 through 2015, with a deal value over $100 million; and, with respect to private deals, announced from June 2012 through 2015, with a target company equity value over $25 million), 49 of them contained an antitrust-related RTF, with the fees ranging from less than 3% (8 deals), between 3% and 4% (10 deals), between 4% and 6% (21 deals), and over 7% (10 deals). Most recently, the trend has been toward more frequent use of, and higher amounts for, RTFs. In the most common formulation, an RTF is a specified amount that is paid if antitrust approval cannot be obtained by the drop dead date or can only be obtained by divesting assets that exceed the Divestitures Cap. Parties may wish to consider alternative structures in order to craft the provision to better meet the parties’ concerns and objectives in the given situation. For example, an RTF: could escalate gradually over time (a so-called “ticking fee”); could increase if antitrust approval has not been obtained after a specified period of time (but before the drop dead date); or (although consideration would have to be given to the increased leverage provided to the regulators) could increase if antitrust approvals would have been obtainable had the acquirer agreed to specified divestitures or divestitures at a specified amount above the Divestitures Cap. “Optionality” Based on Antitrust Developments When negotiating a merger agreement for a deal that presents antitrust concerns, the parties may wish to consider providing in the agreement for a degree of flexibility or “optionality” for one or both of the parties with respect to the transaction, as more information becomes available at various times as to the likelihood and cost of ultimately obtaining antitrust approvals. This approach may be especially useful in deals in which, with respect to the likelihood or costs of ultimately obtaining antitrust approval, there is a high degree of uncertainty, the merger parties have a fundamentally different view, and/or the merger parties have a significantly different level of tolerance for the risk. Basic framework for “optionality.” One possible framework for the concept would be to permit the target company to have the right to terminate the agreement early (before the ultimate drop dead date), at one or more points in time when additional information has become available company based on the likelihood of antitrust approvals ultimately being obtained having become significantly lower, or (in a stock deal) the costs of obtaining the approval having become materially higher, than the target had originally believed would be the case. For example, one formulation could be that, after a specified period of months from signing the merger agreement, the target would have the right to terminate, unless the buyer then increases its commitment to the transaction (through a heightened standard of efforts or additional specific required divestitures); and/ or the buyer increases the compensation to the target in the event approval is not obtained (through a higher RTF); and/or the buyer increases the merger consideration (in the latter two cases, the increase could either be a one-time increase or be done on a “ticking fee” basis, with additional increases over time). Another possible formulation would be to provide the buyer and/or the target company with the right to extend the drop dead date under certain circumstances, such as if the buyer is then litigating with the government, with the buyer’s right, possibly, being subject to the buyer’s increasing the RTF, and the target company’s right, possibly, being subject to a decrease in the RTF. Practical Points on Antitrust Planning (continued from previous page) Practical Points on Antitrust Planning (continues on next page) Page 24 Practical Points on Antitrust Planning (continued from previous page) Other possible formulations. It should be noted that there is a wide variety of ways in which the optionality concept could be utilized, effecting trade-offs between and among various merger agreement provisions, depending on various developments occurring or information acquired after signing. Other examples of possible formulations include: Downward adjustment in merger price based on divestitures. The merger consideration could be adjusted downward if the divestitures required for antitrust approval exceed a specified value or must include specified types of divestitures. For example, the merger agreement for the Sherwin Williams-Valspar transaction announced in March 2016 (an $11.3 billion all-cash deal), which provides for a Divestitures Cap of $1.5 billion (but no RTF), also provides that the $113 cash per share merger price will decrease to $105 per share if the required divestitures exceed $650 million. We note that a graduated scale tied to the amount of required divestitures—rather than the $650 million “cliff” provided for in Sherwin Williams-Valspar—might be a preferable structure in most deals. One disadvantage of a “cliff”-based price adjustment is that, if the divestiture package were close to the specified “cliff” threshold, the buyer would have the incentive to expand the package and cross the threshold to obtain the benefit of the price reduction. This problem could be addressed by having a linear price reduction above the threshold or attempting to contractually limit the buyer’s manipulation of the package under those circumstances. The amount of the merger consideration also (or alternatively) could be adjusted downward based on the type of divestitures required for antitrust approval. For example, an adjustment could be triggered by a need to divest specified assets, or specified brands or types of assets or more than a specified amount of those types of assets. Change in merger consideration from cash to stock. In an all- or part-cash deal, the parties could consider agreeing that, if divestitures exceeding the Divestitures Cap are required, the target company would have the right that, instead of a termination of the deal and payment of the RTF, the merger consideration would be restructured (wholly or partly) from cash to stock—in which case both parties, rather than only the buyer, would share in the “cost” of the divestitures. (Of course, a change in the form of consideration would involve meaningful mechanical and other difficulties that would have to be addressed, including the potential that a stockholder vote of the buyer would be required.) No break-up fee payable by target if other transaction is pursued. To provide a target company with increased leverage in ensuring a satisfactory outcome in the face of significant antitrust uncertainty for the deal with the agreed buyer, the target could be given a right, after a specified period of time or upon certain early developments in the antitrust process, to effect a transaction with a different acquirer, without paying a breakup fee and with it receiving the RTF from the buyer, unless the buyer increases the RTF and/or extends the drop dead date. Other Tactical Issues Effect of provisions on the regulators. One tactical issue to be kept in mind is to what extent the combination of merger agreement provisions that relate to antitrust approval will affect the leverage that the regulators will have in trying to extract remedies or block the transaction. For example, a “hell or high water” provision can increase the regulators’ leverage, particularly if the drop dead date does not provide sufficient time for the parties to litigate in the event the regulators seek to block the deal in court. Similarly, a list of assets (or types of assets), or a specified Divestitures Cap, can provide a “roadmap” and increase the leverage of the regulators, at least with respect to the specified assets (or assets up to the amount of the Cap). The dynamics of each deal will dictate how the parties’ balance the benefits of these types of provisions with the negative inferences that could be drawn from them by the regulators. Political ramifications. Another tactical issue relates to the timing of a transaction based on political considerations. A transaction commenced currently would be subject to the relatively aggressive approach of the regulators described above; whereas a transaction commenced a few months from now would be in the queue for regulatory review under a potentially different regime. The preferred timing would depend on one’s view of the outcome of the upcoming election. Page 25 Lower Risk of Aiding and Abetting Liability for Bankers—Zale and Volcano (Supreme Court) Expansion of Application of Post-Closing Business Judgment Review Under Corwin—Volcano (Supreme Court) Heightened Focus on Deal Certainty—Practice Points for Lowering Risk of Non-Satisfaction of Closing Conditions— ETE-Williams (Court of Chancery) Confirmation that Limited Partnership Agreements Can Eliminate All General Partner Fiduciary Duties With Respect to Affiliated Transactions—Dieckman (Court of Chancery) Lower Risk of Aiding and Abetting Liability for Bankers—Zale and Volcano (Supreme Court) In Singh v. Attenborough (May 6, 2016, en banc, “Zale III”), the Delaware Supreme Court emphasized that bankers generally should not have aiding and abetting liability except in unusual circumstances involving knowing bad faith conduct. The decision, authored by Chief Justice Strine, is notable for apparently reversing the momentum of recent Delaware decisions that have been interpreted as potentially expanding the risk of aiding and abetting liability for M&A financial decisions that have been interpreted as potentially expanding the risk of aiding and abetting liability for M&A financial advisors. In addition, the decision reaffirms the recent trend of Delaware decisions that, as a practical matter, have significantly narrowed the risk of directors being found to have breached fiduciary duties in M&A transactions. The decision likely will have no effect, as a practical matter, on the risk of liability of directors—who, due to exculpation, do not face liability for breaches other than those that involve bad faith. In In Re Volcano (June 30, 2016), the Court of Chancery, confirmed that claims made against a financial advisor for having aided and abetted directors’ breaches of fiduciary duties “may be summarily dismissed based upon the failure of the breach of fiduciary duty claims against the director defendants.” Further, citing Zale III, the court emphasized “the high burden that a plaintiff faces in attempting to plead facts from which a court could reasonably infer that a financial advisor acted with the requisite scienter for an aiding and abetting claim.” Expansion of Application of Post-Closing Business Judgment Review Under Corwin—Volcano (Supreme Court) On June 30, 2016, in In Re Volcano, the Court of Chancery, applying the Supreme Court’s seminal 2015 decision in Corwin v. KKR, as well as Zale III (discussed above), dismissed breach of fiduciary duty claims against the directors of Volcano Corporation, based on approval of the challenged transaction by Volcano’s stockholders in a fully informed vote. In Corwin, the Delaware Supreme Court held that approval of a non-controller merger by the disinterested stockholders, in a fully informed, non-coerced vote, will result in business judgment review of the directors’ actions in a post-closing damages action. In Volcano, Vice Chancellor MontgomeryReeves, clarifying and expanding Corwin, answered a number of questions that Corwin and Zale III left open: Based on Volcano: Under Corwin, the presumption that the business judgment rule standard of review applies is “irrebuttable.” The court wrote: “[R]ecent [Delaware] Supreme Court decisions confirm that the approval of a merger by a majority of a corporation’s outstanding shares pursuant to a statutorily required vote of the corporation’s fully informed, uncoerced, disinterested stockholders renders the business judgment rule irrebuttable.” The business judgment rule standard of review under Corwin will apply in the context of a tender offer. The court extended the Zale III holdings to mergers under Section 251(h) of the Delaware General Corporation Law (the “DGCL”) following a tender offer. The Court held that the acceptance of a first-step tender offer by fully informed, disinterested, uncoerced stockholders representing a majority of a corporation’s outstanding shares in a two-step merger under Section 251(h) had the same “cleansing effect” under Corwin as a fully informed, uncoerced vote of a majority of the disinterested stockholders of a target corporation in a one-step merger. Delaware Update: Delaware Update (continues on next page) Page 26 Delaware Update (continued from previous page) In a Corwin context, the burden of proof will be on the defendant to demonstrate that stockholders were fully informed. The court stated that, although a plaintiff generally bears the burden of proving a material deficiency when asserting a duty of disclosure claim, “a defendant bears the burden of demonstrating that the stockholders were fully informed when relying on stockholder approval to cleanse a challenged transaction.” Under business judgment review, the “waste” standard is applicable. The court confirmed that, under the business judgment standard of review, the applicable standard for a damages finding is “waste.” Practice Points Importance of best practices relating to a sale process. Notwithstanding Corwin, Zale III and Volcano, best practices by boards and bankers in conducting a sale process—including with respect to bankers’ disclosure of actual and potential conflicts of interest and avoiding actions that could be deemed to intentionally harm or defraud the board—will continue to advantage all parties, for reasons relating to business reputation, as well as potential legal liability. Practical impact of different pre- and post-closing standards of judicial review. We note that, even when, under Corwin, business judgment review may apply post-closing, the board will have to plan and manage the sale process to pass muster under the standard of review that will be applicable pre-closing. For example, if a transaction is subject to the enhanced scrutiny of Revlon pre-closing, then, to avoid the transaction being enjoined pre-closing, the board will have to have fulfilled its Revlon duties—even though the court will apply business judgment review (and not Revlon) in a post-closing damages action. Thus, as a practical matter, Corwin and Zale III should not affect pre-closing planning of a transaction. Importance of materially complete disclosure when seeking stockholder action. These decisions serve as a reminder of the importance of materially complete disclosures in connection with stockholder votes, given that a “fully informed” vote is a predicate of business judgment review under Corwin. Indeed, where stockholders bring a preliminary injunction action, pre-closing, challenging the adequacy of disclosures, director and corporate defendants will have the incentive to make supplemental disclosures mooting such claims not only to avoid the risk of an injunction, but to maximize the likelihood of application of the business judgment rule (and thus early dismissal of claims) in any damages action brought post-closing. Tactical considerations regarding disclosure. Stockholder-plaintiffs who believe that they have meritorious disclosure claims may decide not to press such claims in a pre-closing injunctive proceeding, based on an expectation that, if a post-closing damages action is brought, the claims could then be asserted to support the proposition that the stockholder vote was not fully informed and that business judgment review therefore would not be applicable. Moreover, there may be added incentive not to press claims pre-closing, based on the courts’ recent rejection of disclosure-only settlements unless the supplemental disclosure is “plainly material.” We note that defendants may argue that any claims that were known but not pressed pre-closing were effectively waived. Heightened Focus on Deal Certainty—Practice Points for Lowering Risk of Non-Satisfaction of Closing Conditions—ETE-Williams (Court of Chancery) In Energy Transfer Equity v. Williams (June 24, 2016), the Delaware Court of Chancery held that ETE was not obligated to close the transaction pursuant to which it had agreed to acquire Williams. The court’s holding was based on the failure of a mutual condition to closing that ETE’s counsel deliver an opinion that the transaction should be regarded by the tax authorizes as a tax-free exchange. Although ETE had “bitter buyer’s remorse” and wanted to exit the transaction for reasons unrelated to the tax opinion issues, the court concluded that (i) ETE’s tax counsel in good faith believed that it could not issue the tax opinion and (ii) ETE had not influenced its counsel not to deliver the opinion. In response to ETE, merger parties likely will intensify their focus on deal certainty. Although a number of unusual characteristics of the ETE-Williams transaction led to both the issue in the case and the judicial result, ETE highlights Delaware Update (continues on next page) Page 27 that merger parties should understand and seek to redress the risks of (and detriment from) non-satisfaction of closing conditions. Depending on the facts and circumstances, it may advantage a company (particularly a target company—and even more so if the company is foregoing an alternative transaction) to take an aggressive approach in narrowing closing conditions when negotiating a merger agreement. Attention should be paid to each condition, including conditions that have been considered to be customary and have not typically been the subject of dispute. As ETE underscores, this evaluation is particularly important if a condition involves receipt of an opinion from the counterparty’s own advisor, there is a novel deal structure, or the nature of the transaction or market or other conditions may give rise to issues that could result in failure of a condition. These issues were exacerbated in ETE by the facts that only an opinion delivered by ETE’s one named tax counsel could satisfy the tax opinion condition and there was no alternative presented to remedy a failure of receiving the opinion. Practice Points Importance of due diligence to identify and evaluate the potential risks of a deal not being consummated. A primary objective of due diligence should be to identify and evaluate the specific potential risks of the transaction not closing. The parties can then seek to avoid those risks through drafting or advance planning. Specify steps that must be taken to meet the “efforts” obligation and/or specify pre-agreed “back-up” transaction structures. Parties seeking to ensure certainty of closing may wish to specify steps that would be required to be taken as part of the contractually required standard of efforts by the parties to satisfy the conditions. In addition, parties may wish to specify alternative transaction structures that would be put into place in the event that issues arise with respect to certain conditions being satisfied. In connection with a tax opinion condition, the parties could specify that they would have to seek alternative counsel and/or consider restructuring the transaction, or would be obligated to effect a specified pre-agreed restructuring (that might, for example, reduce cash and substitute equity, possibly at a fixed ratio). In connection with a stockholder approval condition, the parties might wish to explore the feasibility of providing that, if approval of the acquiror’s stockholders were required and could not be obtained, the parties would restructure the transaction (including by converting equity consideration to cash or non-voting securities) so that a stockholder vote would not be legally required. Alternative formulations of tax opinion condition. In addition to a party’s named tax counsel that will be engaged to provide the tax opinion to it, the parties may wish to name more than one firm and/or to provide that any nationally recognized law firm may be engaged to provide the opinion. Parties may wish to consider the feasibility of providing that their respective counsel will select a third firm to determine whether an opinion can be issued (and to issue it) if one party’s counsel cannot deliver the opinion but the other party’s counsel can; or, alternatively, they may consider agreeing that the condition will be satisfied if either party’s counsel delivers the opinion to both parties. In lieu of a tax opinion condition, the parties could agree that the tax opinions be delivered at signing, with the condition being that there is no change in the tax laws that would materially adversely affect the validity of the opinion. (Note that this formulation does not protect the parties against changes in the factual context that could affect the tax outcome (e.g., a decline in stock price) and would necessarily turn the closing condition opinion into a “hypothetical opinion” in that the opinion would express a view as to the tax results of a future transaction based on assumed facts the accuracy of which cannot be known with certainty until closing actually occurs. As noted, the parties could agree in advance that they will restructure, convert the form of consideration, and/or take other steps necessary to address any substantive tax issue that may arise and prevent issuance of the opinion. Parties could agree in advance to waive a tax opinion condition if the potential tax liability (or net tax liability) is not “material” or does not exceed a specified amount or other standard. Where there is a higher potential than usual that issues may arise with respect to satisfaction of the tax opinion Delaware Update (continued from previous page) Delaware Update (continues on next page) Page 28 condition—and, particularly, where the condition is based on issuance of the opinion by a party’s own counsel, or the standard of certainty for the opinion is high, the other party may seek to negotiate that a meaningful reverse termination fee will be payable in the event that the condition is not satisfied. If one party has the predominant underlying economic interest with respect to a tax opinion, consideration should be given to only that party being protected by the condition. “True” hell-or-high water approach. A possible response to ETE may be that target companies become more aggressive in seeking to achieve agreements that come closer to a true “hell-or-high-water” standard than in the past (particularly when the target has abandoned an alternative transaction). For example, a target company may seek: to provide that the only bases on which the parties would not be obligated to close would be that legally required approvals are not obtained; or that the other party willfully breached its covenants set forth in the merger agreement, with a material adverse effect; larger termination fees than in the past—more akin to the type of termination fees seen in regulatory-sensitive deals—and/or that the termination fee would be payable if the transaction is terminated for any reason other than failure of a short list of specified conditions (we note, though, that if termination is in favor of a competing bid, then, generally, a usual termination fee should be applicable); and/or direct payment by a topping bidder of any breakup fee that the target may have to pay in connection with a transaction that the target will be terminating to accept the topping bid (so that, even if the topping transaction does not ultimately close for any reason, the termination fee payable by the target with respect to the abandoned transaction would have been paid by the topping bidder). Precatory language underscoring the commitment to closing. Parties seeking to maximize deal certainty could consider including precatory language in the merger agreement that expresses their strong commitment to closing and that requests that, in the event of a future dispute, a court interpret the merger agreement provisions to favor respecting the parties’ intent that the transaction close. Such language would underscore the parties’ intentions and should influence a court’s interpretation of the agreement provisions. Include lititgators early in the negotiation and drafting process. Litigators should be included early in the negotiation and drafting process to seek to ensure that the merger agreement reflects the parties’ intentions with respect to deal certainty. Drop dead date should provide time to resolve issues. A target company may seek a right for longer-term extensions of a drop dead date than in the past (possibly, unless a larger than usual breakup fee is paid by the buyer). Merger parties should consider whether the drop dead date should be extendable in the event of unresolved litigation issues, or if other developments challenge deal certainty, or if the passage of time could (or would be likely to) eliminate the circumstances that have caused a failure of the condition (such as time for market dislocations to clear). Confirmation that Limited Partnership Agreements Can Eliminate All General Partner Fiduciary Duties With Respect to Affiliated Transactions—Dieckman (Court of Chancery) In Dieckman v. Regency (March 29, 2016), the Court of Chancery again confirmed that the contractual arrangements set forth in a limited partnership agreement will define the respective rights and obligations of the partners, including with respect to the general partner’s fiduciary duties (and related duty of disclosure) in connection with affiliated transactions. The decision continues the Delaware courts’ general approach of providing the highest level of protection against limited partners’ challenges to transactions between a master limited partnership and its general partner or the general partners’ affiliates—so long as: the partnership agreement clearly limits or eliminates fiduciary duties and provides a clear process for approval of the transaction (a so-called “safe harbor,” which typically involves approval by a conflicts committee of the general partner); and the process established in the partnership agreement is followed. Delaware Update (continued from previous page) Delaware Update (continues on next page) Page 29 Historically, master limited partnership agreement provisions relating to affiliated transactions were important only infrequently, principally in connection with the occasional dropdown of assets by a general partner to the partnership. We note that, with current difficult market conditions affecting oil and gas industry MLPs, transactions between MLPs and their affiliates have become more common (and are likely to become increasingly so). Not only dropdowns, but also rollups and insider financings and equity investments, have become more common as general partners seek to provide liquidity, simplify structures, create synergies, and/or improve the financial position of the partnership. Practice Points Dieckman serves as a reminder that a partnership agreement should clearly define the extent to which the general partner’s obligations and the unitholders’ rights under the law are being contractually modified. Provisions that would be most protective for a general partner include the following: Elimination of fiduciary duties. A partnership agreement can provide that all fiduciary duties of the general partner are eliminated. Conflict committee safe harbor process for affiliated transactions. In almost all cases, approval by a conflicts committee of the general partner will provide the easiest and quickest safe harbor process for affiliated transactions. The partnership agreement can provide that the committee membership may be small (for example, as in Dieckman, two or more directors) and can define broadly the independence requirements for the members. (In Dieckman, the independence definition required that the committee members were not at the same time serving as directors of affiliates of the general partner. We note that it is not necessary to have such a restrictive definition of independence.) Standard for approval by conflicts committee. A partnership agreement can define narrowly the standard that will apply to a conflicts committee’s decision to approve an affiliated transaction. Often, the standard set forth is that the persons making the decision hold a subjective belief that the decision is in the best interests of the partnership. In addition, a partnership agreement can include a provision that there is a conclusive presumption of good faith by the conflicts committee when it relies on an opinion provided by legal or financial advisors. Unitholders safe harbor process for affiliated transactions. If, as in the Regency situation, a partnership agreement provides for a safe harbor process involving approval by the unaffiliated unitholders, we note that, unlike the Regency provision that called for approval by a majority of the unaffiliated units outstanding, the requirement could be for a majority of the unaffiliated units voting. (The Regency merger was approved by 67% of the unaffiliated units outstanding, which represented 99% of the unaffiliated units voting.) Disclosure obligation. A partnership agreement can provide for a very limited disclosure obligation of the general partner in connection with the unitholders’ approval of a transaction (such as the obligation only to provide a copy or summary of the merger agreement). Of course, disclosure obligations under the federal securities laws still would apply (but would not give rise to contractual liability under the partnership agreement). Importantly, while, a partnership agreement can provide for very limited obligations of a general partner in connection with affiliated transactions, the process established in the agreement must be followed, and the general partner will be advantaged to the extent that the committee (notwithstanding the elimination of fiduciary duties by contract) performs diligently. Conflict committee members should: Meet the independence requirements for membership; Know the standard for the committee’s approval of the transaction; Ensure that they have the information necessary to make a determination that meets the standard for approval; Be appropriately engaged in the process of considering the transaction; Delaware Update (continues on next page) Delaware Update (continued from previous page) Page 30 Consider retaining independent financial and legal advisors and, if advisors are retained, ask questions to ensure that the advice and analyses are understood, consider obtaining a fairness opinion or legal opinion, and remain in control of the committee process; Consider whether to negotiate the terms of the transaction with the parent company (unless the determination is clear, some level of negotiation with the parent company is often advisable as a basis for forming a good faith judgment about the transaction); and Make a determination that meets the standard for approval (tracking the language set forth in the partnership agreement with respect to the standard of approval) and memorialize their determination in the formal record of the committee’s deliberations. As always, the factual context is important. While the court extends a high degree of deference to partnership agreement provisions, the facts and circumstances can affect the court’s result. In Dieckman, the court relied only The overall factual context in Dieckman included a conflicts committee that engaged in a process that included obtaining unitholder approval (which was required by statute for a merger) and a fairness opinion; the pleadings did not include allegations of an egregious result; and there was no indication that the committee members had not formed the requisite belief that the transaction was in the best interests of the partnership. Not all of these facts were relevant to the court’s determination (which addressed only on the partnership’s safe harbor that was based on obtaining approval of the unaffiliated unitholders, and not the alternative safe harbor that was based on conflict committee approval based on the committee members’ belief that the transaction was in the best interests of the partnership), but they may have influenced the court’s view. We note that, by contrast, in the 2015 El Paso situation, in the context of extreme negative facts relating to the conflict committee’s process, the court deemed the conflict committee approval to have been ineffective. In El Paso, the court concluded that the committee did not in fact form a subjective view that the dropdown transaction at issue was in the best interests of the partnership. Emphasizing the incomplete, inaccurate, and “manipulative” nature of the information provided to the committee by its financial advisor, as well as the committee’s ignoring information it had relating to the partnership’s other recent dropdown transactions, the court’s view appeared to be that the committee did not have a base of information upon which it was even possible to form a subjective belief as to whether the transaction was in the partnership’s best interests. Notably, in El Paso, there was no unitholder approval and, critically, there were contemporaneous emails among the committee members that indicated that they actually believed that the transaction would not be in the best interests of the partnership. Delaware Update (continued from previous page) New York Update: New York Update (continues on next page) NY Adopts Delaware’s MFW Approach to Going-Private Mergers – Kenneth Cole NY Applies Delaware’s Approach to Bad Faith Duty of Loyalty Claims – Central Laborers NY Narrows Attorney-Client Privilege as Applied to Merger Parties’ Sharing of Legal Strategies – Ambac Kenneth Cole In Kenneth Cole Productions Inc. Shareholder Litigation (May 5, 2016), the New York Court of Appeals established that New York courts will follow the approach to going-private mergers taken by the Delaware Supreme Court in its seminal 2014 decision in Kahn v. MFW. The Court of Appeals expressly adopted the MFW approach, without any qualification. As a result, in New York, as well as Delaware, a challenge to a merger with a controlling stockholder will be reviewed by the courts under the deferential business judgment rule, rather than the more stringent “entire fairness” standard of Page 31 New York Update (continued from previous page) review, if certain protections for minority stockholders are in place. The critical protections are that, from the outset of the transaction, the controlling stockholder conditioned the transaction on obtaining approval from (i) a fully authorized and effectively functioning special committee of independent directors and (ii) a majority-of-the-minority stockholders in a fully informed and un-coerced vote. Notably, in Kenneth Cole, the Court of Appeals emphasized its commitment to the MFW doctrine, stating that the MFW business judgment rule standard applies at the pleading stage and cannot be frustrated by conclusory or artful pleadings. (Delaware’s post-MFW jurisprudence has taken the same approach.) Whether a controlling stockholder will choose, in any given case, to subject a transaction to a vote of the minority stockholders in order to obtain review under the business judgment rule (and thus, as a practical matter, obtain early dismissal of fiduciary duty claims against the directors), will depend on the facts and circumstances of the particular case—including: 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). Central Laborers In Central Laborers v. Dimon (Jan. 6, 2016), the U.S. Court of Appeals for the Second Circuit, applying Delaware law, affirmed the dismissal of claims that directors of JPMorgan Chase (a Delaware corporation) had breached the duty of loyalty by failing to institute internal controls sufficient to detect Bernard Madoff’s Ponzi scheme. The decision reaffirms that, in New York, as in Delaware, claims based on alleged failures to implement and oversee a corporation’s information systems and controls (so-called “Caremark claims”) will be dismissed absent egregious misconduct by the directors involving bad faith. The court cited the Delaware Supreme Court’s Stone v. Ritter decision, which held that a Caremark claim must be based on directors having (a) “utterly failed to implement any reporting or information system” or (b) “having implemented such a system or controls, consciously failed to monitor or oversee its operations” (emphasis added). Rejecting the plaintiffs’ argument that they needed to show only that the defendants utterly failed to implement “reasonable” controls, the court stated that the “plain language [of the Stone decision] could not be any clearer—‘any’ simply does not mean ‘reasonable.’” The Court also reasoned that Caremark itself spoke in terms of a “failure to attempt” to implement controls as constituting the “bad faith” required to impose liability when directors are subject to standard provisions in corporate charters that exculpate them from liability for breaches of duty other than those involving bad faith or disloyal conduct. The court commented that a bad faith duty of loyalty breach is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” Ambac In Ambac v. Countrywide (June 9, 2016, slip op.), New York’s highest court, considering a merger agreement that was governed by Delaware law, rejected a common interpretation of the so-called “common interest exception” to the attorney-client privilege. The New York Court of Appeals held that, in New York, to avoid a waiver of the attorney-client privilege when privileged information has been shared between parties that have a common legal interest, the information must have been shared in connection with pending or reasonably anticipated litigation. We will review this decision is depth in an upcoming Fried Frank M&A Briefing. Page 32 M&A/Private Equity Group Partners: If you would like to receive the Fried Frank M&A/PE Quarterly via email, you may subscribe online at friedfrank.com/subscribe. New York Abigail P. Bomba email@example.com Andrew J. Colosimo firstname.lastname@example.org Warren S. de Wied email@example.com Aviva F. 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