Inside M&A - July 2007
July 2007
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Lessons from Caremark
By Whitman Burns and Jake Townsend
In a recent decision relating to the proposed merger of Caremark RX, Inc. and CVS Corporation, the Delaware Court of Chancery emphasized that certain aspects of the proposed merger structure gave rise to additional disclosure requirements and additional shareholder rights (Louisiana Mun. Police Employees’ Retirement Sys. v. Crawford). A “special cash dividend” declared by Caremark prior to the merger, but payable only upon the approval and closing of the merger, was deemed to be cash consideration paid in connection with the merger, which in turn entitled the shareholders to appraisal rights. Also, because the bulk of a fee paid to investment banks was in part triggered by the initial approval of the transaction, the fee was necessarily “contingent” and therefore required disclosure to the Caremark shareholders of the conditions precedent to the payment of the fee to the banks.
Special Dividend Gives Rise to Appraisal Rights
Appraisal rights under Delaware law were triggered by a “special cash dividend” declared in connection with the proxy fight between CVS and Express Scripts, Inc. for Caremark. In response to a competing bid from Express Scripts, the Caremark board declared a special cash dividend. While the dividend was declared before the merger, the special cash dividend would be paid only if the merger was approved by Caremark shareholders and subsequently consummated.
Caremark and CVS claimed that the special cash dividend was separately approved and payable by Caremark, and therefore had “independent legal significance” and should not be deemed merger consideration, which would require appraisal rights. The Delaware Chancery Court rejected this argument in this context. The court held for the first time that the special cash dividend declared before the merger, but conditioned upon the approval and consummation of the merger, was nothing more than “none-too-convincing” disguised merger consideration. In this respect, the court stated that while the special cash dividend was declared by the Caremark board, it was nonetheless “fundamentally cash consideration paid to Caremark shareholders on behalf of CVS.” Further, the court noted that even Caremark stated in its public disclosures “that the special cash dividend might be treated as merger consideration for tax purposes.” The court explained that “shareholders should not be denied their appraisal rights simply because their directors are willing to collude with a favored bidder to ‘launder’ a cash payment.” Because Caremark did not inform shareholders of their appraisal rights, the court ordered that the shareholder meeting to approve the merger be enjoined for the required 20-day notice period under statute.
Contingent Investment Banking Fees Subject to Disclosure Requirements
In general, the nature and structure of non-contingent investment banking fees are not believed to require specific disclosure to shareholders. However, the Caremark decision makes clear that certain non-contingent aspects of a fee may, in fact, be contingent and therefore require disclosure.
In this case, UBS and JPMorgan rendered fairness opinions regarding the Caremark/CVS merger. The initial delivery of the opinions triggered a payment, regardless of the conclusion reached, of $1.5 million to each firm. In addition, each firm was entitled to receive a $17.5 million “success” fee upon public announcement and consummation of the merger or other specified alternative third-party transactions. Caremark argued that because the approval and public announcement of the merger had already occurred by the time public disclosures about the fee were made, the only contingency that remained was the consummation of the merger.
The court disagreed and found Caremark’s disclosure of the fees to be misleading due to its failure to describe the initial requirement that the firms had to meet in order to receive their fees (i.e., initial endorsement by the banks of the merger and subsequent public disclosure). Without an initial favorable recommendation from the banks, there would be no public announcement of the merger and a condition for the payment of the “success” fee would not be met. The court concluded: “It follows then that where a significant portion of bankers’ fees rests upon initial approval of a particular transaction, that condition must be specifically disclosed to the shareholder. Knowledge of such financial incentives on the part of the bankers is material to shareholder deliberations.”
NASD (formerly known as the National Association of Securities Dealers) has also addressed disclosure of investment banking fees by proposing Rule 2290. The proposed rule would require NASD members receiving fairness opinions to disclose in proxy materials compensation contingent upon the successful completion of such transaction. Rule 2290, which was originally proposed in 2005 and recently resubmitted to the Securities and Exchange Commission, has not yet been formally adopted and is awaiting final review and approval by the SEC.
Wayward Management
By Bronwyn Andreas, Morgan Fox-Walbridge and Rachel Hundley
Last month, The Dow Chemical Company fired two senior executives accused of purportedly engaging in unauthorized discussions with third parties concerning a potential takeover bid for the company. In a sense, the timing of their alleged actions could not have been worse, as Delaware courts have recently released a number of (predominantly critical) decisions on the topic.
Recent Decisions
Delaware courts have expressed increasing skepticism as to management’s intentions in negotiating buyouts due to inherent conflicts of interest. In some cases, such as In re Netsmart Techs., Inc. and Louisiana Mun. Police Employees’ Ret. Sys. v. Crawford (also known as the Caremark case), where they found that management’s interests have been materially unaligned with those of shareholders, the courts have required additional disclosure of all material information regarding the fairness of the offer and the preceding negotiations.
In contrast, in 2005, the Delaware Court of Chancery approved of the sale process implemented by the board of directors of Toys “R” Us, Inc. to sell the entire company to a private equity group. In this case, the court rejected the plaintiff’s argument that the CEO had an improper motivation to support the deal due to the more than $60 million he stood to gain as a result of the transaction. The court lauded the process adopted by Toys’ special committee whereby the CEO did not “[tilt] the process towards any bidder” and only negotiated his own compensation package after the board had settled on a strategic option.
Not all companies subject to Delaware judicial review have been so fortunate. In early 2007, the Delaware Court of Chancery expounded upon the role management should play in buyouts in two cases. In Netsmart Techs, Inc., the court found the special committee failed to explore transactions with strategic buyers and failed to adequately supervise management in the sale process. The court considered the negotiation process defective because the board did not actively balance the conflicting incentives of shareholders and management. As a result, the court ordered disclosure of all material information related to the negotiations. In Caremark, the court also expressed concern over the personal incentives of the company’s CEO in favoring the merger with CVS over competing offers. Because of the CEO’s possible interest in promoting one transaction over another, the court ordered the directors to disclose all material information about the transaction.
Dow Chemical
In the current cases involving Dow Chemical and its two executives, the Delaware Chancery Court may have the opportunity to again address the relationship between management and the board in connection with a buyout. The court may also address the questions left unanswered in its 2006 decision involving SS&C Technologies (In re SS&C Techs., Inc., Shareholders Litigation). In that opinion, the court questioned whether it was prudent for the CEO to use information and resources of the corporation without board authorization to arrange a buyout. Because the issue was not raised by the plaintiffs, the court felt it was not appropriate to address the question at that time.
Whether the Dow Chemical cases will go to trial in Delaware remains to be seen. What is certain, however, is that management’s use of proprietary company information to formulate a buyout without board approval is likely to be deemed a violation of management’s duty of loyalty owing to Delaware corporations. Participation by management in negotiating buyouts should be carefully supervised by the board, even in the early stages of transaction negotiations.
By Samuel Wales
In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court, in a case of first impression, addressed the ability of creditors to assert claims for breach of fiduciary duty against directors of a Delaware corporation that is insolvent or operating within the zone of insolvency. The Court unequivocally held that, as a matter of law, a creditor cannot assert a direct claim in either situation and that, when a corporation is insolvent, a creditor can only assert a derivative claim for breach of fiduciary duty against the corporation’s directors. See Gheewalla, 2007 Del. LEXIS 227, 24-25, 31-32 (Del. May 18, 2007).
Unanswered Questions
One of the questions that remains unanswered in the Court’s opinion is whether a creditor can assert derivative claims for breach of fiduciary duty against directors when the corporation is operating within the zone of insolvency. While the Court did not specifically address this issue, the Court strongly suggested that creditors are precluded from asserting derivative claims in such situation. First, the Court observed that, in questioning whether it was necessary for creditors to have a right to assert claims for breach of fiduciary duty against directors of a corporation operating within the zone of insolvency, the Delaware Court of Chancery in several cases noted that creditors already have specific legal protections through “their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law.” Id., at 23 (citing North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 WL 2588971, at *13 (Del. Ch. Sept. 1, 2006); Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 790 (Del. Ch. 2004); Big Lots Stores, Inc. v. Bain Capital Fund VVI, LLC, 2006 WL 846121, at *8 (Del. Ch. Mar. 28, 2006)). Second, the Court pointedly noted that directors of a Delaware corporation owe their fiduciary duties to the corporation’s shareholders and that such duties do not change when a corporation begins to operate within the zone of insolvency. The Court stressed that “[w]hen a solvent corporation is navigating in the zone of insolvency, . . . directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Id. at 25 (emphasis added). Finally, the Court stressed that insolvency, and not the zone of insolvency, is the dividing line when derivative claims of breach of fiduciary duty shift from the stockholders of a corporation to its creditors.
“When a corporation is solvent, [directors’] fiduciary duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.” Id., at 26 (emphasis in original).
As a result, the Court’s highlighting of the existing legal protections available to creditors, the Court’s strong focus on the fiduciary duties owed by directors to the corporation’s shareholders, and the Court’s emphasis on creditors’ ability to enforce derivate claims only after a corporation’s insolvency all strongly suggest that the Court views creditors as having no right to bring derivative claims for breach of fiduciary claims against directors of a corporation that is operating within the zone of insolvency.
Advising Directors
The Court’s opinion in Gheewalla provides definitive guidance to boards of Delaware corporations that are insolvent or operating within the zone of insolvency, including those considering a sale or comparable transaction involving a change of control of the corporation. While a Delaware corporation is operating within the zone of insolvency, directors owe fiduciary duties to the corporation’s stockholders and must exercise their business judgment in the best interests of the corporation and its stockholders. After a Delaware corporation becomes insolvent, directors continue to owe the same fiduciary duties, but the corporation’s creditors replace its stockholders as the primary constituency affected by any breach of such duties. As a result, as long as directors of an insolvent corporation continue to make business judgments that are in the best interests of the corporation and its constituencies, creditors of the corporation will have difficulty successfully asserting any claim of breach of fiduciary duty.
Buyer Beware: Prohibitions Against Rescission in Case of Seller Misrepresentation Enforced
By Hal Schwartz, Heather W. Harrington and Joanna Lin
A current trend in the M&A market highlights the increasing leverage of private equity firms selling portfolio companies. Purchase and sale agreements in which private equity firms are sellers frequently include indemnification provisions that specifically prohibit certain extra-contractual buyer remedies (such as rescission for fraud or misrepresentation). They often contain very low caps on the seller’s liability for breaches of representations and warranties and short survival periods for representations and warranties. In deals in which private equity buyers are looking to minimize their post-closing exposure to unknown liabilities and private equity sellers are looking to make clean breaks after selling portfolio companies in order to promptly distribute the sale proceeds, both parties may need to look to third parties (such as insurance companies) to achieve these somewhat conflicting objectives.
ABRY Partners V, L.P. v. F&W Acquisition LLC
In ABRY Partners V, L.P. v. F&W Acquisition LLC, the Delaware Chancery Court enforced provisions in a stock purchase agreement that severely limited the seller’s liability to the buyer for claims arising out of material misrepresentations in the agreement. Three months after closing the $500 million acquisition of F&W Publications, Inc., a magazine publishing business owned by private equity firm Providence Equity, the buyer (a group of entities affiliated with the private equity firm ABRY Partners) sued to rescind the agreement based upon claims of fraudulent inducement and negligent misrepresentation. ABRY alleged that Providence collaborated with F&W in misrepresenting material facts in financial statements and operational conditions of F&W to fraudulently induce ABRY into paying an artificially inflated selling price. The purchase agreement contained three important provisions:
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It contained a “non-reliance” clause that eliminated any seller liability for the buyer’s reliance upon any representations
or information outside of the four corners of the agreement. - It capped the seller’s liability for indemnification claims to
an aggregate of $20 million. - It provided that claims under the indemnification provisions would serve as the buyer’s exclusive remedy for misrepresentations (barring rescission claims).
In its ruling to enforce the agreement, the court concluded that “Delaware law permits sophisticated commercial parties to craft contracts that insulate a seller from a rescission claim for a contractually false statement of fact that is not intentionally made.”
The ABRY decision does not suggest that parties can insulate themselves from liability if a buyer can prove the seller’s fraud. The court specifically noted that where a buyer is able to demonstrate either that the seller knew that the contractual representations of the company being sold were false or that the seller itself intentionally lied to the buyer about such representations, an exclusive remedy provision could not insulate the seller against fraud claims under such circumstances. One distinction that influenced the court was that the allegedly fraudulent statements were made by F&W and not by Providence, and ABRY could not demonstrate to the court that Providence knew about the fraudulent nature of F&W’s representations. The court further noted that a buyer asking for rescission when alleging fraud on the part of a seller must prove that the “seller acted with an illicit state of mind,” meaning that the seller “knew that the representation was false and either communicated it to the buyer directly itself or knew that [the portfolio company] had.”
Alternative Means of Protecting Buyers
Given the increasing negotiating power of sellers with respect to indemnification provisions, buyers may want to consider looking to insurers to help reduce the risk of unknown liabilities that may arise after the closing of an acquisition. They may wish to look to representations and warranties insurance (RWI) policies, which can reduce their exposure to the unpredictability of post-closing losses.
RWI has several straightforward and practical benefits. First, buyers can purchase it for their benefit when a seller is only willing to accept very low caps on its indemnification obligations or short survival periods for the representations and warranties, or when the seller refuses to provide an escrow to support indemnity claims. RWI can also reduce the amount of time and energy the parties spend negotiating the terms of the seller’s indemnification obligations. Additionally, the buyer may be able to procure RWI for periods that exceed the agreed upon survival of the representations and warranties in the purchase agreement. This could be particularly valuable with respect to liabilities that may surface after closing, such as environmental hazards or title issues.
Lastly, enlisting an insurance company as a neutral third party to distribute funds according to liability may be more desirable than using an escrow fund, which generally requires consent from the seller to pay indemnification claims.
Impact of the Companies Act on UK Mergers & Acquisitions
By Nicholas Azis and Brigid Breslin
The Companies Act 2006 represents the largest reform of company law in the United Kingdom in more than 20 years. It is being implemented in stages with full implementation expected by October 2008. As it will apply to mergers and acquisitions activity in the United Kingdom, the key implications may be summarized as follows.
The Takeover Panel
Since 1968, takeover regulation in the United Kingdom has been overseen by the Panel on Takeovers and Mergers, which administered rules and principles contained in the non-statutory City Code on Takeovers and Mergers. In order to bring United Kingdom takeover regulation within the requirements in the EU Takeovers Directive, the Act places the Panel’s powers and the Code on a statutory basis, but in practice the Code and the Panel’s position as a non-statutory body and the regulator of mergers and acquisitions in the United Kingdom will remain largely unchanged.
To date, takeovers in the United Kingdom have rarely been the subject of litigation. Will the statutory framework mean that takeovers in the United Kingdom will be battled out in the courts? This is unlikely to be the case. Provisions in the new Act are intended to limit litigation by channeling parties to seek decisions of the Panel (with an escalating procedure) before allowing for judicial recourse, as well as excluding new rights of action for breach of statutory duty, protecting concluded transactions from challenge for breach of the Panel’s rules, and exempting the Panel, its members and staff from liability for damages in connection with the discharge of the Panel’s functions.
The Act will not affect the availability of judicial review by the courts. However, in the case of R v. Panel on Takeovers, ex parte Datafin plc (1987) in the United Kingdom, the Court of Appeal generally concluded that courts should limit themselves only to reviewing the Panel’s decision-making processes after the bid has been concluded. Accordingly, litigation in the context of takeovers in the United Kingdom has been very rare and is not expected to increase significantly.
Squeeze-Outs and Sell-Outs
“Squeeze-outs” and “sell-outs” are designed to address the problems resulting from residual minority shareholders following a successful takeover bid. Squeeze-out rights enable a successful bidder to compulsorily purchase the shares of the remaining minority shareholders who have not accepted the offer. Sell-out rights enable minority shareholders, in the wake of a bid, to require the acquiror to purchase their shares. The rules in the Directive are broadly consistent with the existing companies legislation in the United Kingdom. Squeeze-out and sell-out rights apply upon the acquisition of 90 per cent of the target’s shares, but the Directive goes further in also requiring those shares to carry 90 per cent of the voting rights. This second test is also included in the new Act.
In practice, as in the United States, each share generally has one vote, so in most instances there will be no higher threshold to achieve. However, the time period during which the squeeze-out rights may be exercised has been changed to three months following the time allowed for acceptance of the bid; for sell-outs, the period is either three months from the end of the offer or, if later, three months following shareholders being notified of their rights.
