Delaware Supreme Court Decision in Omnicare, Inc. v. NCS Healthcare, Inc.
April 15, 2003
On the basis of Omnicare, it appears that an agreement that fully locks up a proposed merger vote and contains no fiduciary out will not be enforceable under Delaware law.
On November 22, 2002, Vice Chancellor Stephen Lamb of the Delaware Court of Chancery denied the request by the plaintiffs, stockholders of NCS Healthcare, Inc., for a preliminary injunction enjoining the proposed merger between NCS and a wholly owned subsidiary of Genesis Health Ventures, Inc. On December 10, 2002, in a summary decision that surprised many practitioners, the Delaware Supreme Court issued an order reversing the Court of Chancery. The Delaware Supreme Court’s long awaited opinion released on April 4, 2003, explains the reasoning behind its summary decision in this case.
Case Notes
Jon Outcalt, the chairman, and Kevin Shaw, the CEO, owned a majority of the voting power of NCS. In late 1999, NCS began to experience financial difficulties and started to explore strategic alternatives. By early 2001, NCS was in default of much of its outstanding debt and its share price was below $1. NCS engaged in discussions with Omnicare, Inc. whereby Omnicare made a series of proposals, each of which was conditioned upon completion of due diligence and was not for a merger, but rather, for a purchase of assets out of bankruptcy. Under each proposal, the NCS creditors would be partially paid, and the NCS stockholders would not receive any compensation.
In June 2002, NCS engaged in negotiations with Genesis in which Genesis proposed a merger transaction that provided for full recovery by NCS’s debt holders and unsecured creditors and the payment of Genesis common stock equal to $1 in value for each share of NCS common stock. In July 2002, Omnicare learned of the negotiations and proposed a merger whereby the debt holders and creditors of NCS would be fully paid and the stockholders would receive $3 per share. In the proposal, however, Omnicare continued to insist on the completion of confirmatory due diligence.
NCS informed Genesis of Omnicare’s proposal. In response, Genesis substantially improved the terms of its proposal in exchange for a merger agreement that did not contain a “fiduciary out” and voting agreements with Outcalt and Shaw pursuant to which they agreed irrevocably to vote all of their shares (which constituted more than a majority of the voting power of NCS) in favor of the merger. As permitted by Section 251(c) of the Delaware General Corporation Law, the merger agreement also contained a “force the vote” provision requiring NCS to submit the merger agreement to the NCS stockholders for a vote whether or not the NCS board continued to recommend the merger. On July 28, 2002, the NCS board approved the merger agreement and the voting agreements, and NCS and Genesis signed the merger agreement and Outcalt and Shaw signed the voting agreements.
On October 6, 2002, Omnicare committed itself to a transaction with NCS where by the company agreed to tender for all outstanding shares of NCS for $3.50 per share, with no due diligence condition. The NCS board withdrew its recommendation of the NCS/Genesis merger agreement and NCS’s financial adviser withdrew its fairness opinion. Omnicare and certain NCS stockholders then sought an injunction to invalidate the merger agreement and the voting agreements.
Holding by the Court of Chancery
The Court of Chancery held that the plaintiffs failed to establish a reasonable probability of success on the merits of their claims for a variety of reasons:
First, the Court of Chancery held that the plaintiffs failed to show that the defensive provisions of the merger agreement coupled with the voting agreements violated the standard set forth in Unocal Corp. v. Mesa Petroleum Co. They were found to be preclusive, coercive or unreasonable in relation to the threat posed. Second, the court held that the duty under Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. to obtain the best value reasonably available where a change of control is contemplated did not apply to the proposed NCS/Genesis transaction because it was a stock-for-stock merger pursuant to which NCS stockholders would receive shares of an issuer without a controlling person or group. Finally, the court found that the NCS directors properly exercised their fiduciary duties to the extent possible, given the exclusivity agreement with Genesis, the interests of the debt holders (as NCS was in the zone of insolvency and a merger was far preferable to a sale out of bankruptcy) and the risks attendant to Omnicare’s demand for completion of confirmatory due diligence.
Reversal by the Supreme Court
In the view of a majority of the Delaware Supreme Court, the appropriate standard of review for deal protection devices that lock-up a transaction is not the business judgment rule but rather the enhanced scrutiny standard of Unocal. It also appears, from the court’s decision, that the reasonableness of deal protection measures are to be evaluated at the time a competing bid emerges, and not at the time the merger agreement is entered into. The absence of a “fiduciary out” provision in the merger agreement made the deal protection measures (i.e., the Section 251(c) “force the vote” provision coupled with the stockholder voting agreements that represented a majority of the votes on the merger) both preclusive and coercive.
Contrary to the finding of the Court of Chancery, these deal protection devices were not reasonable and proportionate to the threat that NCS perceived from the potential loss of the Genesis transaction. The court stated, “[T]he record reflects that any stockholder vote would have been robbed of its effectiveness by the impermissible coercion that predetermined the outcome of the merger without regard to the merits of the Genesis transaction at the time the vote was scheduled to be taken.”
Importantly, the Supreme Court was not unanimous in its decision, as it almost always is in decisions involving significant issues of corporate law. Chief Justice E. Norman Veasey and Justice Myron Steele dissented on the grounds that it is not the court’s role to second guess the reasoned judgment of a properly functioning board of directors and disregard the wishes of controlling stockholders. The dissenting justices argued that where a fully locked-up transaction results from a lengthy and reasoned process to which Revlon does not apply, there is no reason to adopt a rule that a merger agreement without a “fiduciary out,” coupled with an agreement locking-up stockholder approval, is invalid per se. The dissenters also noted that the fully locked-up transaction was not unreasonable in light of Omnicare’s financially superior bid because, at the time of signing the merger agreement, Omnicare’s bid was conditioned on completion of confirmatory due diligence. Genesis would not have entered into the NCS/Genesis merger agreement unless it was assured that the transaction would close (Genesis had previously lost a transaction as a result of Omnicare) and if the Genesis deal did not get signed, Omnicare might decrease its bid and revert back to the purchase of assets out of bankruptcy structure. Using language particularly strong for the Delaware Supreme Court, the dissenters referred to the majority holding as “unwise and unwarranted” and “clearly erroneous.”
Prior to this opinion, many practitioners believed that in a stock-for-stock merger that is not subject to Revlon, a target board of directors could agree to a fully locked-up deal if it satisfied its duty of care. Based on this decision, a target board should insist that any merger agreement that it approves that contains a “force the vote” provision also contain a fiduciary out if the transaction has the irrevocable support of holders of a majority of the target’s voting power. Alternatively, there are other structures that may permit a “locked-up” transaction or a virtually locked-up transaction, in the right circumstances.
