Two recent decisions of the Delaware Court of Chancery, In re Topps and In re Lear Corporation, consider a number of important legal issues that arise in the context of public M&A transactions. Among them are the following:
Management conflicts of interest. Delaware courts have recently expressed concern that the interests of senior management in negotiating friendly mergers may not be materially aligned with the interests of shareholders, particularly due to assurances by the buyer of continued employment.1 Under the so-called Revlon standard, when directors propose to sell a company for cash or engage in a change of control transaction, they must take reasonable measures to ensure that shareholders receive the highest value obtainable. As the Delaware Court stated in Topps, "When directors bias the process against one bidder and towards another not in a reasoned effort to maximize advantage for the stockholder, but to tilt the process toward the bidder more likely to continue current management, they commit a breach of fiduciary duty."
In Topps, the Topps board approved entering into a merger agreement with a private equity group led by former Disney CEO Michael Eisner. Eisner had assured to Topps’ managers that their employment would be continued after the merger, and this was not adequately disclosed in the proxy materials. No such assurances existed in the case of a competing offer by a strategic buyer, Upper Deck. The essence of the claim by plaintiffs in Topps was that a majority of the board had been motivated by a desire to ensure that Topps would remain under the control of a friendly buyer who would continue present management, including family members of the company’s founder. The court found that the Topps board had likely breached its fiduciary duty by failing to try to negotiate a better deal with Upper Deck and enjoined Topps from proceeding with a shareholder vote on the Eisner merger until Topps had amended its proxy statement to disclose all of the facts regarding Eisner’s assurances that he would retain existing management.
In Lear Corporation, the company entered into a merger agreement with Carl Icahn, a significant shareholder (24 per cent) at the time. For purposes of negotiating with Icahn, the Lear board set up a special committee. However, because this committee apparently did not view Icahn’s proposal to buy the company as presenting a conflict for Lear’s CEO and senior management team, the special committee "did not insert itself or its advisors into the merger negotiations." Rather, it "stood back from the frontlines of due diligence and the negotiation of price and other merger terms," allowed the CEO to "spearhead" the negotiations, and engaged the company’s long-standing outside counsel and the company’s financial advisors as its own advisors.
At the time of the merger negotiations, Lear’s CEO had much of his wealth tied up in Lear stock and unsecured retirement benefits with a value of $14.6 million. The retirement benefits could be cashed out for $10.4 million, but only if the CEO retired. Shortly before the merger talks with Icahn, the CEO had approached the compensation committee and expressed interest in accelerating his retirement benefits. Discussions were held with Lear’s compensation consulting firm. Proposals were made, but none accepted. None of this was disclosed in the proxy materials. The merger agreement allowed the CEO to cash out his equity stake and receive accelerated scheduled payments of his retirement benefits while retaining his employment with the company on improved terms.
Although the court ultimately did not find that there had been a breach of the Revlon standard or that the CEO had acted inappropriately, it was highly critical of the process, noting that the negotiation process was "far from ideal and unnecessarily raises concerns about the integrity and skill of those trying to represent Lear’s public investors." The court stated that "it would have been preferable for the Special Committee to have had the chairman or, at the very least, its lead banker participate with [the CEO] in the negotiations with Icahn … It could have provided [the CEO] with more substantial guidance about strategy he was to employ." The court remarked as follows in enjoining Lear from proceeding with the shareholder vote on the Icahn merger until supplemental disclosure of the CEO’s arrangement had been fully disclosed:
Because the CEO might rationally have expected a going-private transaction to provide him with the unique means to achieve his personal objectives, and because the merger with Icahn in fact secured for the CEO the joint benefits of immediate liquidity and continued employment that he sought just before the negotiating of that merger, the Lear stockholders are entitled to know that the CEO harbored material economic motivations that differed from their own that could have influenced his negotiating posture with Icahn. Given that the special committee delegated to the CEO the sole authority to conduct the merger negotiations, this concern is magnified.2
Post-signing market checks. In both Topps and Lear, merger agreements were signed after negotiations with a single bidder, without the benefit of any pre-signing auction or meaningful market check. As a practical matter, when a bidder approaches a target to negotiate a possible merger, it will often require, as a condition of pursuing negotiations, that no such pre-signing auction or market canvass take place. When the consideration being proposed fully values, or potentially fully values, the target, it will be difficult for a board to refuse this demand, since it risks the bidder withdrawing its offer, to the detriment of shareholders. Without any pre-signing market canvass, a board must then rely on a ‘post-signing market canvass’ to satisfy its Revlon duty to maximize shareholder value.
In both Topps and Lear, no meaningful pre-signing market check was conducted, on the insistence of Eisner and Icahn, respectively. In both cases, the Delaware Court found the post-signing market check to be sufficient in the circumstances, noting that the deal-protection measures (go-shop, break fee, matching right3) were reasonable and would not deter a serious rival bid. These conclusions are welcome particularly in light of the recent Netsmart decision, which found that Netsmart’s "inert, implicit post-signing market check" did not suffice in the circumstances as a reliable way to survey interest by strategic buyers.
In Lear, the court makes a point of distinguishing Netsmart:
Netsmart was a micro cap company with limited trading in its shares. Only one analyst covered it. By contrast, Lear is one of the largest corporations in the United States with deep analyst coverage…. Put simply, unlike in Netsmart, no one had to discover Lear; they were invited by Lear to obtain access to key information and decide whether to make the bid.
However, unlike the merger agreement in Topps and Lear, the Netsmart merger agreement did not provide a ‘go-shop,’ and it is not clear what weight the court gave to this factor.
Standstills. In Topps, Upper Deck was prevented by the terms of a standstill it had signed with Topps from publicly commenting on its competing offer and from launching a formal tender offer. The Topps board refused Upper Deck’s request to be released from the standstill on the basis that its offer was too contingent, though the merger agreement with Icahn expressly permitted the Topps board to waive the standstill "if its fiduciary duties so required." The court found that, in the circumstances, the refusal by the Topps board to release Upper Deck from the terms of the standstill was a "misuse" of the standstill that likely amounted to a breach of the board’s Revlon duty, since it denied shareholders the chance to accept a potentially more attractive, higher priced deal. In reaching this conclusion, the court discussed the use of standstills. While observing that standstills can be abused and can be used by a target improperly to favour one bidder over another, it recognizes that they can serve a legitimate purpose — for example, in an auction process where promising the winning bidder that the standstill agreements that bind the losers will not be waived will no doubt help in extracting the highest bid.
Standstills have been the object of two recent Canadian decisions.4 It is particularly interesting to compare the decision in Topps with the recent decision of the Ontario Court of Appeal in Ventas. In Ventas, Ventas sought an order requiring Sunrise to enforce the provisions of a standstill it had previously entered into with Health Care Properties, a rival bidder to Ventas for Sunrise, on the basis that Sunrise had undertaken to do so under the merger agreement it had entered into with Ventas following an auction process. Unlike in Topps, this merger agreement did not permit Sunrise to release Health Care from its standstill if the board determined "its fiduciary duties so required." Rather, it required Sunrise to enforce, and not waive or amend, the provisions of any standstill previously entered into.5 The court upheld the strict terms of the merger agreement and did not allow them to be overridden by any overarching "fiduciary" obligation.