Trends and Developments in M&A (Part I): Public Company Targets

© 2014 Winston & Strawn LLP
Trends and Developments in M&A (Part I): Public Company Targets
April 22, 2014

©2014 Winston & Strawn LLP 2
Today’s Speakers
Oscar A. David
Chair, Mergers & Acquisitions/ Securities/Corporate Governance
Chicago
(312) 558-5745
odavid@winston.com
Eva Davis
Chair, West Coast Private Equity
Los Angeles
(213) 615-1719
evadavis@winston.com
Robert J. Rawn
Partner, Mergers & Acquisitions/ Securities/Corporate Governance
New York
(212) 294-6721
rrawn@winston.com

Overview of Public Deal Activity

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Volume of global mergers was down 6% to $2.4 trillion, slowest year since 2009.*
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However, total value of deals with U.S. targets increased 11.3% to $1.04 trillion.*
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Several large deals made in 2013:
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Verizon’s $130 billion acquisition of 45% of Verizon Wireless – third largest deal ever.
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Other large deals include the acquisitions of Heinz by Berkshire Hathaway/3G Capital ($27.4B) and Dell by Michael Dell/Silver Lake ($24.9B).
Overview of Deal Activity – Mixed Results in M&A in 2013
* The American Lawyer. March 31, 2014.

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In the U.S., there were 140 public company acquisitions valued at $100 million or more, down from 143 in 2012, 157 in 2011 and 181 in 2010. 14 acquisitions were valued at $5 billion or more.*
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Consistent with the past several years, split in U.S. public deals was roughly 75% strategic and 25% financial. *
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Most active sector was banking and financial services, followed by software and electronics and pharmaceuticals and biotechnology.*
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Percentage of stock deals remained consistent at about 30%.*
Overview of Deal Activity – Breakdown of 2013 Public Deals
* What’s Market: 2013 Public M&A Wrap-up. Practical Law Company. February 1, 2014.

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Reasons to be optimistic in 2014:
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Companies have plenty of cash on hand and are getting pressure to use it.
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Financial sponsors also have large reserves of capital
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Accessible/inexpensive debt financing.
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1Q 2014 – More Megadeals:*
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$710 billion worldwide in announced deals – half from deals worth $5 billion or more.
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However, the number of deals dropped by 14%, slowest year-to-date period by number of deals since 2003.
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Top deals announced in the first quarter include pending acquisitions of Time Warner Cable by Comcast ($70.6B) and Forest Laboratories by Actavis ($24B).
Overview of Deal Activity – Outlook for Remainder of 2014
* A string of mega deals drives global M&A recovery in first quarter. Reuters. March 27, 2014.

Financial Advisor Conflicts

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Delaware courts are carefully scrutinizing the actions of boards of directors and financial advisors when conflicts of interest impact the sale process.
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Whether the conflict is known or unknown, the courts may find the Board responsible if a conflict of interest is viewed as tainting the sale.
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Financial advisors may be held liable for aiding and abetting a Board’s breaches of fiduciary duties.
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Three Recent Cases:
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In re Del Monte Foods Company (February 2011)
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In re El Paso Corporation (February 2012)
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In re Rural Metro Corporation (March 2014)
Financial Advisors and Conflicts of Interest – Recent Cases

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Del Monte – addressed unknown conflicts of interest:
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Financial advisor, without informing the corporation, (i) allowed two buyers to team up to make a joint bid in violation of no-teaming provisions in the confidentiality agreement and (ii) sought to obtain staple financing from potential buyers.
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When the conflicts were finally disclosed, the Del Monte Board allowed them, without extracting any concessions.
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Stockholder vote on the buyout was temporarily enjoined by the Court but later went through.
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Del Monte and the financial advisor ultimately agreed to an $84.3M settlement with stockholders ($23M paid by the financial advisor and the rest by Del Monte).
Del Monte and El Paso

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El Paso – addressed known and unknown conflicts of interest:
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Financial advisor disclosed its significant minority ownership in potential buyer of El Paso.
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El Paso had publicly announced plan to spin-off one of its two businesses.
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Primary financial advisor continued in its role on the spin-off. Secondary financial advisor was brought in to “cure the conflict” but would only get fee if sale of whole company occurred. Court viewed this as a distorted financial incentive for the secondary financial advisor.
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Case also involved undisclosed conflicts, including lead banker for primary financial advisor personally owning $340K in stock of acquirer. Court was highly critical of sale process but declined to enjoin the vote.
Del Monte and El Paso

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Financial advisor to Rural/Metro pitched a special committee of the Board on potential sale:
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Disclosed to Rural/Metro that it hoped to provide staple financing to bidders of Rural/Metro.
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Did not disclose that it also sought to provide buy-side financing to bidders of EMS, a primary competitor of Rural/Metro undergoing a sale process at the same time.
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The special committee agreed to hire the financial advisor, despite not having full Board approval to hire a sell side advisor or start a sale process.
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The financial advisor promoted a process that focused on EMS bidders, in order to obtain potential buy-side financing engagements from EMS bidders. Financial advisor only focused on financial buyers (more likely to require financing) and no interest was elicited from strategic buyers.
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The financial advisor’s potential fees in connection with a financing would greatly exceed fees in connection with its advice on the sale process.
Rural/Metro - Background

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Financial advisor focused on a near-term sale:
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Many potential Rural/Metro bidders could not fully participate in process due to their involvement in the EMS process – some bidders (including the winner of the EMS auction) requested an extension of the bid deadline, which the Board rejected.
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Reversed its previous advice that Rural/Metro further build value through acquisitions before putting itself up for sale.
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Ultimately, only one PE fund made a bid for Rural/Metro, which was accepted by the Board.
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Financial advisor made a significant push to obtain a role in PE fund’s financing:
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Offered a $65 million revolver for another portfolio company of the PE fund.
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Court noted the financial advisor “re-doubled its efforts on the financing front and played nice on the deal front.”

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The financial advisor’s questionable fairness opinion:
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Opinion delivered by financial advisor’s “ad hoc” fairness committee (as opposed to a standing committee staffed by senior bankers).
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One member of the ad hoc committee had never previously served on a fairness committee.
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The financial advisor’s questionable valuation advice:
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The Board received the financial advisor’s valuation analysis only hours before the merger agreement was approved.
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The day prior to the merger, the financial advisor (as well as the secondary advisor) made several decisions which had the effect of reducing the valuation significantly, making the merger price appear more attractive.
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The Court found that the financial advisor’s valuation analysis contained outright falsehoods – did not add back to EBITDA $6.3M charge for one-time expenses, claiming that Wall Street analysts’ consensus does not make such adjustments, which was false.

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The financial advisor was found to have aided and abetted breaches of the Board’s fiduciary duty. (Both the Board and a secondary financial advisor settled before trial.)
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Rural/Metro had adopted an exculpatory 102(b)(7) provision, which eliminates monetary damages for breach of a director’s duty of care, but this does not protect non-directors.
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Because of the conflicts of interest, the Court’s standard of review is “enhanced scrutiny” – an intermediate test between the business judgment rule and the entire fairness standard.
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Conflicts of interest “do not comfortably permit expansive judicial deference.”
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Board’s action must lie within a range of reasonableness.
Rural/Metro - Holding

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Court held that the Board breached its fiduciary duties in the sale process:
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Sale process in parallel with the EMS process was not reasonable: not authorized by the full Board, improperly influenced by the financial advisor and made by decision makers who suffered due to these conflicts of interest.
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Board failed to provide active and direct oversight of the financial advisor.
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At the current time, the Court has not decided on the appropriate remedy – parties are to prepare revised briefings to determine fair value of Rural/Metro.
Rural/Metro - Holding

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Conflicts of interest cause the Court to be skeptical about the entire process.
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Hiring a second financial advisor is not, by itself, sufficient – especially when it does not cure other conflicts (Rural/Metro) or when such second financial advisor is subject to distorted incentives (El Paso).
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Boards must issue clear mandates to committees which must be followed – In Rural/Metro, the Court took significant issue with the special committee’s lack of authority to pursue the sale.
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Staple financing is not necessarily inappropriate, but can be risky from a conflict of interest perspective, especially if other sources of financing in the debt markets are available.
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Financial advisors and Boards should pay attention to fairness opinion procedures – Court deeply skeptical of “ad hoc” fairness opinion committee used by Rural/Metro’s financial advisor.
Financial Advisor Conflicts - Lessons and Takeaways

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Boards can protect themselves with a well-run (and well-documented) process. In particular, the Delaware courts in Rural/Metro took note of Board meeting minutes prepared long after the meeting and minutes with a “feel of a document drafted in anticipation of litigation.”
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Acknowledging a conflict is not enough - the Court will expect the Board to obtain something of value for allowing a financial advisor to have a conflict of interest.
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General disclosures in an engagement letter are not sufficient:
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Rural/Metro’s financial advisor’s engagement letter contained language that it provides other financial products and services to companies that may be involved in the potential sale.
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Informing the Board of potential conflicts before engagement does not relive a financial advisor of its obligation to inform the Board of actual conflicts as they arise.
Financial Advisor Conflicts - Lessons and Takeaways

Two-Step Merger and Section 251(h) of the Delaware Corporate Law

Two-Step Merger and Section 251(h) of the DGCL
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Background
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Public company acquisitions are typically structured as either (1) a one-step long- form merger or (2) a two-step merger that begins with a tender offer and is followed by a back-end squeeze out merger.
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Prior to the Burger King transaction (March 2010), the delay and costs associated with acquiring the equity of a target that was not purchased in the tender offer were significant disadvantages of the two-step merger structure.
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If the buyer failed to own 90% of a target company’s voting securities after the tender offer, the buyer could not consummate a “short-form” merger and would need to obtain stockholder approval.

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Since Burger King, to the extent there were sufficient authorized shares available, Buyers would often include a “top-up” option in the merger agreement, which granted the buyer the right (and in some cases, the obligation) to acquire an amount of shares of the target necessary to reach the 90% threshold.
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“Top-Up” options are limited to the extent that the target company has insufficient authorized but unissued shares. Amending the target company’s charter to increase the authorized shares requires stockholder approval and would typically not be an optimal path to pursue relative to a one-step merger.
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For deals without significant time consuming regulatory approvals, one-step mergers and two-step mergers (with “top-up”) got buyers, sellers and stockholders to the same end result, but the one-step merger process (due to shareholder approval requirements) took months longer.

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On August 1, 2013, the Delaware General Corporation Law was amended to add Section 251(h) which, subject to certain conditions, permit a back-end merger to be consummated following a tender offer that results in the buyer acquiring at least enough of the target’s shares to approve the merger (but less than 90%).
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17.5% of deals in the first half of 2013 were structured as tender offers
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37.9% of deals signed after August 1, 2013 were structured as tender offers
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Since August 1, 2013, only one Delaware-governed tender offer did not opt-in to Section 251(h)
Source: “What’s Market 2013 Year in Review: Looking back and the Road Ahead” – www.practicallaw.com

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The target’s shares must be listed on a national securities exchange or have more than 2,000 stockholders of record immediately prior to the execution of the merger agreement.
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The buyer must be a corporation.
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The target’s certificate of incorporation must not contain a requirement for a stockholder vote to consummate a merger.
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The merger agreement must expressly provide that it will be governed by Section 251(h) and be approved by the target’s board.
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The merger agreement must provide that the second- step merger be effected as soon as practicable following the consummation of the tender offer.
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The tender offer must be for any and all outstanding stock of the target that, absent Section 251(h), would be entitled to vote to adopt the merger agreement.
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Following consummation of the tender offer, the buyer must own at least the required percentage of the outstanding shares of each class or series of stock of the target that would have been required to approve the merger agreement (typically a majority).
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The consideration paid for shares in the second-step merger must be the same amount and kind of consideration paid to stockholders in the tender offer.
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No party to the merger agreement may be an “interested stockholder” as defined in Section 203 of the DGCL (i.e., a 15% owner, together with its affiliates), at the time the merger agreement is approved by the target’s board.
In order to qualify for Section 251(h), the following conditions must be satisfied:

Pros
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Often utilized for mergers where the buyer is financing the transaction with loans and the lenders do not wish to provide bridge financing for the purchase of shares in a first-step tender offer.
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In a transaction where the merger consideration consists of shares of the buyer, the timing advantages of a two-step merger are less pronounced.
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Beneficial structure if the transaction requires a significant amount of time between signing and closing to obtain 3rd-party approvals.
Cons
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SEC review
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Stockholder vote
Pros
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If the buyer is paying all cash, the two-step merger can be completed quickly, without prior SEC review.
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Can opt-in to Section 251(h) and do not need to obtain 90% in order to effect the back-end merger. Eliminates the need for the top-up and dual-track structure work-arounds.
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No stockholder vote; front-end speed; deal certainty
Cons
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If the target has debt or other obligations that will become due upon the change of control, the buyer must be prepared to refinance or pay the obligations in full, which could be more difficult because the buyer does not own 100 percent of the target.
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A financing closing condition requires an additional 5 business day notice period.
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Section 251(h) prohibits a 15% owner (together with its affiliates) from being party to the merger agreement.
Comparison of One-Step and Two-Step Mergers
One-Step Merger
Two-Step Merger

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Eliminate the prohibition against the statute’s use in circumstances where a party to the merger agreement is an “interested stockholder.” Eliminates any questions as to whether buyer’s entry into voting agreements make the buyer an “interested stockholder.”
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Clarify that the merger agreement may either permit or require the merger to be effected under Section 251(h), enabling the parties to agree that the proposed merger under Section 251(h) may be abandoned in favor of a merger accomplished under a different statutory framework.
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Clarify certain timing and other requirements in respect of the back-end merger.
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Clarify that the tender offer may exclude stock owned by the target corporation.
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Apply to merger agreements entered into on or after August 1, 2014.
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Do not change the fiduciary duties of directors.
Proposed Amendments to Section 251(h)

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On occasion, the SEC has required PE funds to directly sign on as a bidder in tender offers, exposing the PE fund to potential liability in two-step mergers for misleading disclosures under federal securities laws and for non-performance.
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Including a financing condition in a merger agreement under Section 251(h) will require an additional 5 business day notice before consummating the tender
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The SEC’s funding position forces buyers with committed financing to:
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(i) secure and pay for financing in escrow for all outstanding shares 5 business days in advance of the tender offer’s consummation, regardless of how many shares are actually tendered or whether the tender offer will be successful, or
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(ii) waive any funding condition 5 business days in advance of the expiration of the tender offer and potentially take the risk that the funding does not materialize.
Private Equity Considerations Under Section 251(h)

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Section 251(h) prevents buyers from entering into “agreements, arrangements and understandings” regarding the acquisition or voting of shares of the target with holders of the target’s stock in advance of the time the target board approves the merger agreement if such agreements or understandings would result in the buyer “owning” more than 15% of the target.
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Equity rollovers do not count towed the ownership threshold required by Section 251(h) because the rollover shares are not owned by the buyer when the tender offer closes.
Private Equity Considerations Under Section 251(h)

NDA/Standstills and “Don’t Ask, Don’t Waive” Provisions

NDA/Standstill and “Don’t Ask, Don’t Waive” Provisions - Overview
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Public target companies seeking to be sold in an auction process will typically include a “standstill” provision in the confidentiality agreements signed by bidders. The standstill provision prohibits the prospective buyer from acquiring ownership of the target without the express consent of the target board.
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Ex: For a period of [___] from the date hereof [or until such earlier time as a Sale of the Target occurs], the Potential Buyer and its affiliates will not (and neither such Potential Buyer nor its affiliates will assist, provide or arrange financing to or for others or encourage others to), directly or indirectly, acting alone or in concert with others, unless specifically invited on an unsolicited basis in writing in advance by the board of directors of the Target: (i) acquire or agree, offer, seek or propose to acquire (or request permission to do so), ownership (including, but not limited to, beneficial ownership as defined in Rule 13d-3 under the Exchange Act) of any of the assets other than inventory in the ordinary course of business) or businesses of the Target or any securities issued by the Target, or any option or other right to acquire such ownership (including from a third party);

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The standstill often includes a provision – which has become known as a “don’t ask, don’t waive” provision – restricting a bidder from making any public or private requests to the board to waive or amend the provisions of the standstill.
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In an auction process, there will typically be a “best and final” round, from which the target company will select one bidder for final negotiations.
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The target company will then enter into a definitive merger agreement that will include “fiduciary out” provisions, which generally results in a “back door” auction as the board has the ability to consider “superior proposals,” essentially making the announced acquiror a stalking horse.
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When combined with a “no-shop” provision (or even modest “go-shop” provision), the winning bidder generally has strong deal protection.
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A “don’t ask, don’t waive” provision further strengthens those deal protections by preventing bidders from earlier rounds to publicly or privately requesting waivers of the standstill provision and sometimes expressly prohibiting the target from waiving the standstill provision.
NDA/Standstill and “Don’t Ask, Don’t Waive” Provisions - Overview

NDA/Standstill and Don’t Ask, Don’t Waive Provisions – Key Cases
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In re Complete Genomics, Inc. Shareholder Litigation, C.A. No. 7888-VCL (Del. Ch. Nov. 9, 2012) (transcript ruling) – Vice-Chancellor Laster
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VC Laster enjoined the enforcement of the DADW provision because it impermissibly limited the Genomics board’s “ongoing statutory and fiduciary obligations to properly evaluate a competing offer, disclose material information, and make a meaningful merger recommendation to its stockholders.”
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To get the best price, Genomics board needed to allow another bidder to come back with a topping offer, notwithstanding the DADW provision.
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Did not question the validity of a prohibition against public waiver requests but reasoned that private waiver requests constituted a “bidder-specific no-talk clause,” which courts generally hold to be invalid.

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In re Celera Corporation Shareholder Litigation, C.A. No. 6304-VCP (Del. Ch. Dec. 4, 2012) – Vice Chancellor Parsons
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Shareholder class action filed on behalf of Court-appointed lead plaintiff New Orleans Employees' Retirement System challenging the acquisition of diagnostic testing company Celera Corporation by Quest Diagnostics Incorporated.
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Following discovery, the parties entered into a memorandum of understanding to settle the case. Vice Chancellor Parsons analyzed DADW provisions in the context of approving a proposed settlement.
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The Court found the interplay of the DADW provision with a non-solicitation provision troubling because the DADW provision blocks once-interested parties from informing the target board of their desire to bid and the non-solicitation provision prevents the board from inquiring further into any potential interest from those parties.
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The Court noted that there is “at least a colorable argument that these constraints collectively operate to ensure and informational vacuum […] [and increase] the risk that the Board would outright lack adequate information […].”

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In re Ancestry.com, Inc. Shareholder Litigation, C.A. No. 7988-CS (Del. Ch. Dec. 17, 2012) (transcript ruling) – Chancellor Strine
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Chancellor Strine clarified that there is no per se Delaware rule against DADW provisions and they are generally enforceable.
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Recognized that not allowing DADW provisions may debilitate the auction process, but also emphasized that DADW provisions are “potent” and are subject to careful judicial review.
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Compared the effect of a DADW provision to an auction gavel, thereby producing the highest short-term value reasonably available to stockholders.
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The Court was troubled that the “board was not informed about the potency of this clause […] the CEO was not aware of it […] [and] it’s not even clear the banker was aware of it.”
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The provisions are enforceable as long as the board has made an informed and reasoned decision to use them for the intended purpose.
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The board should disclose its use of DADW provisions the company’s proxy statement to shareholders.

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Koehler v. NetSpend Holdings Inc., 2013 Wl 2181518 (Del. Ch. May 21, 2013) - Court of Chancery, unpublished opinion - Vice-Chancellor Glasscock
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In a preliminary injunction opinion, VC Glasscock found that the board of NetSpend Holdings Inc., comprised of four directors representing private equity-affiliated stockholders that owned over 45% of NetSpend’s shares, three independent directors and the CEO, likely failed to satisfy their Revlon duties to attempt to secure the best value reasonably attainable when agreeing to sell the company to Total Systems Services, Inc. in an all-cash $1.4 billion transaction.
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NetSpend entered into two NDAs with two private equity firms interested in acquiring a minority stake in NetSpend. The board had indicated that NetSpend was not for sale.
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A strategic buyer approached NetSpend, the board indicated its interest in a sale, and discussions with the private equity funds were terminated.
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The board did not consider the effects and possible waiver of the DADW provisions in the NDAs when changing its mind about the sale of the company to the strategic buyer.
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VC Glasscock acknowledged that DADW standstills can be justified to create an actual auction-like process, but in NetSpend’s situation, once its board determined that there was to be a likely sale to the strategic buyer, the Directors’ Revlon duties applied and the board’s decision to continue the vitality of the DADW provisions and to import them into the Merger Agreement were not informed, logical or reasonable actions.

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There is some uncertainty regarding the enforceability of DADW provisions in the auction process and a target company seeking to bind potential acquirers to DADWs that survive a merger agreement faces some risk.
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The Delaware courts have abstained from taking a position on the value-maximizing role of DADW standstill provisions.
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More restrictive DADW provisions should be combined with a minimal fiduciary out that would allow bidders bound by the standstill to request a waiver if certain clearly articulated new information were to come to light (or otherwise provide a sunset or “fall away” provision).
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A court will likely scrutinize the process surrounding the decision to include standstills, including the board’s involvement; therefore, the board should document its process.
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Those considerations for including standstill and any DADW provisions should also be communicated to the target’s stockholders.
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A court may find that a combination of the DADW and non-solicitation covenant in the merger agreement amounts to a breach of the board’s fiduciary duty, as suggested in Celera and Genomics.
NDA/Standstill and Don’t Ask, Don’t Waive Provisions – Takeaways

Appraisal Rights Arbitrage

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Appraisal rights are a state statutory remedy, generally available in connection with a cash-out merger. In Delaware, stockholders have a statutory right to an appraisal of the value of their shares by the Delaware Court of Chancery.
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DGCL 262 - Basic requirements for appraisal:
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Stockholder must hold shares through the effective date of the merger.
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Stockholder must not vote in favor of the merger and must, prior to the vote on the merger, notify the corporation of its intent to seek appraisal rights.
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Stockholder must not accept merger consideration until the appraisal action is resolved.
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Stockholder must petition the Court of Chancery for appraisal within a specified time after the closing.
Appraisal Rights in Delaware

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Difficult to perfect appraisal rights – strict compliance with statutory procedures is required.
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A stockholder’s merger consideration is in limbo until the appraisal action is resolved, which may take years.
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Court has broad discretion to determine fair value, which may be higher or lower than the merger consideration.
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Stockholders have to pay their own legal fees in an appraisal action.
Prior to 2007, Appraisal Rights are Generally an Afterthought

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Appraisal rights arbitrage became a viable strategy after the Court’s decision in the 2007 Transkaryotic case, where the court held that any beneficial owner through DTC (national clearinghouse for stock), regardless of when the beneficial owner acquired its shares (even after record date of stockholder meeting), could seek appraisal rights.
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Appraisal rights arbitrageurs buy up stock before a deal closes and can then decide, if the conditions are favorable, to bring appraisal claims after the closing.
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Sometimes the threat of appraisal litigation is enough to increase the purchase price (e.g., Carl Ichan’s threat to bring appraisal actions in connection with the Dell sale).
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Why now?
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Statutory interest rate
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Increased stockholder activism
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Courts willing to find a higher fair value
Appraisal Rights Arbitrage: The Strategy

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Stockholders bringing appraisal rights are entitled to interest:
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Statutory interest rate is the Federal Reserve discount rate plus 5%. The interest is compounded quarterly from the closing of the merger until the payment of the award. The statutory interest rate is currently 5.75%.
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Given current market conditions, this is an attractive return. Arbitrageurs can profit even if the Court does not increase the merger consideration in an appraisal action.
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The DGCL provides for payment of interest, regardless of outcome, unless the Court finds “good cause shown”, usually interpreted to mean bad faith. Court is reluctant to deviate from the statutory standard. In a recent case (CKx), the Court rejected a motion to allow a corporation to pay the undisputed portion of an appraisal claim in order to stop statutory interest.
Interest Rates

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Increase in capital to activist hedge funds – even smaller companies are now targeted by activist funds.
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Some hedge funds have been specifically formed to pursue appraisal claims.
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Increase in mergers that tend to arouse shareholder objection – including management buyouts, private equity acquisitions and distressed sales.
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At least four hedge funds exercised appraisal rights in connection with the recent Dole Foods MBO.
Increased Stockholder Activism

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Court has broad discretion to determine fair value and can use any valuation methodologies it deems appropriate – trials generally center around testimony of opposing experts.
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While the Court can choose a higher or lower price, one review of Delaware case law found that 80% of appraisal claims result in a higher price.*
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3M/Cogent appraisal - not much weight given to the merger price as evidence of fair value and Court focused on the expert testimony.
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However, in the CKx appraisal, the Court concluded that expert valuations were not accurate assessments and that the deal price was a “reliable indicator of value.” May be a unique case given that CKx was a holding company with an assortment of assets and businesses.
Value Determination in Appraisal Cases
* Unlocking Intrinsic Value Through Appraisal Rights. Jeremy Anderson & Jose P. Sierra - Law360. Sept. 10, 2013.

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The number of appraisal claims has increased over the past several years.
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One study found that appraisal claims were brought with respect to 15% of takeovers in 2013 and that the value of such claims was $1.5 billion, ten times the value of such claims in 2004.*
Trends
* Corporate Governance Update: Shareholder Activism in the M&A Context. David A. Katz and Laura A. McIntosh. March 27, 2014.

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Appraisal claims are no longer an empty threat - acquirers and targets will need to be aware of this tactic when negotiating a merger.
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While appraisal claim procedures are often too cumbersome a remedy for an individual stockholder, sophisticated hedge funds can successfully navigate the appraisal process.
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Acquirers may consider appraisal-related closing conditions, e.g., ability for a buyer not to close if more than 5-10% of the stockholders assert appraisal rights. However, this may give a small number of stockholders “hold-up value” to delay or prevent a transaction.
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Some calls for new legislation – does appraisal rights arbitrage protect minority shareholders or is this just manipulation by sophisticated investors?
Lessons and Takeaways

What’s Market?

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No-Shop/Go-Shop
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Break-Up Fees/Reverse Break-Up Fees
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Material Adverse Effect
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Contingent Value Rights
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Shareholder Activism
What’s Market?

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No solicitation:
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Target may not solicit or encourage an acquisition proposal or provide any nonpublic information about the target in connection with a third party acquisition proposal
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Fiduciary exception:
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Target not prohibited from providing nonpublic information if expected to result in a superior offer
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“Expected” (98%) v. “Actual” (2%)
Deal Protection: No-Shop Provision

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Must establish the existence of Superior Offer to engage with potential alternative bidder
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Superior Offers*
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Target board must believe that negotiations with alternative bidder could be expected to result in Superior Offer
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What percentage of target constitutes a Superior Offer?
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82% of deals = 50% or greater but < all or substantially all
Deal Protection: No-Shop Provision
*ABA 2013 Strategic Buyer/Public M&A Deal Points Study

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Definition: provision which allows target to solicit competing bids and provide confidential information for a specified time period following merger agreement
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Go-shop prevalence in public M&A
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Depends on market check conducted prior to execution of merger agreement
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Full-blown auction unnecessary, but absent market check, there will be strong preference for go-shop provision
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88% of 2013 public deals did not have go-shop provision
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Note re Background of Merger Section on tender offer/proxy documents
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Time Period—most common is 30 days
Deal Protection: Go-Shop Provision

Modified go-shop increase-two tier fee structure
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Lower fee if deal terminated because of unsolicited proposal
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Higher fee if deal terminated because of solicited proposal
Grandfather clauses increased
–Target can continue negotiations past go-shop time period if bidder proposal submitted during go-shop period
Go-Shop Provision Transformations in 2013
Go-shops in deals with strategic buyers increased
Go-shops in financial deals decreased

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Devices to address risk of transaction not closing
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Break-up fee—Payable by target in certain situations where target does not complete transaction
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Superior alternative proposal
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Intervening event
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Reverse Break-Up Fee—Payable by acquirer when it cannot complete transaction in certain circumstances
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Financing
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Antitrust
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Value of Break-up fee v. Reverse Break-up fee—No longer symmetrical
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Break-up fees—3% to 5%
•
See later charts for Reverse Break-up fees
Break-Up Fees; Reverse Break-Up Fees

Naked No-Vote Fee
Fee for No-Vote + Acquisition Proposal
Drop-Dead Date + Acquisition Proposal
Change in Board Recommendation
Breach of No-Shop or Meeting Covenants
Target Break-Up Fee Triggers

•
Break-up fee characterized as liquidated damages
–
38% in 2012
–
23% in 2011
–
25% in 2010
•
Break-up fee NOT characterized as liquidated damages
–
62% in 2012
–
77% in 2011
–
75% in 2010
Target Break-Up Fees: Liquidated Damages*

•
Reverse breakup fees: principal tool to allocate financing failure risk
–
68% of leveraged deals included, payable if:
•
Buyer materially breaches, or
•
Transaction fails to close
•
Size of fee as % of deal value in debt-financed deals
–
5-7% (42 deals)
–
2-4% (12 deals)
–
>8% (3 deals)
–
1% (1 deal)
Reverse Break-Up Fees/Financing Failure Risk*
*PLC Deal Protections and Remedies: 2013 Analysis of Public Merger Agreements

•
TPG Capital acquisition of Assisted Living Concepts, Inc. was largest reverse break-up fee of 2013 (by percentage)
–
Fee = 14% of deal value if TPG Capital fails to close merger
–
Equity-financed deal (more typically in debt deals)
•
One pure option structure in 2013
–
Sole remedy for breach is reverse break-up fee
Reverse Break-Up Fees/Antitrust Risk

•
14 deals in 2013 included reverse break-up fee for not securing antitrust approval (similar to 2012)
–
Change in 2013 in how risk is allocated
•
Ticking fee included in 2 deals: merger consideration increases each day closing is delayed because of failure to obtain approval
•
Antitrust break-up fee as % of deal value*
–
5% (5 deals)
–
2-4% (6 deals)
–
7% (2 deals)
–
>8% (2 deals)
Reverse Break-Up Fees/Antitrust Risk*

•
Typical MAE Walk Right: Since date of deal, there have not been any material adverse change in the business, financial condition or results of operations of target
•
Increase in unusual carve-outs
–
Government shutdown or debt ceiling impact (4 deals)
–
Labor disputes unrelated to deal announcement (2 deals)
–
Seasonal fluctuations in target’s business (3 deals)
•
MAE thresholds (e.g., specific monetary threshold trigger)
Material Adverse Effect “MAE”

MAE Clause
General Economy
Industry
Announcement
Change in law
Change in Accounting Principle
War/ terrorism
Fail to Meet Projection
Common MAE Carve-Out Clauses

•
Definition: Right which entitles public target company stockholders to additional consideration post-closing if payment triggers satisfied
•
6 Public M&A deals included CVRs in 2013*
–
5 pharmaceutical/healthcare deals
–
1 telecommunications deal
•
Triggers varied from deal to deal
–
Achievement of sale milestones
–
Regulatory approval milestones
–
Share of proceeds from sale of a license
–
Ongoing litigation outcome
Contingent Value Rights (“CVRs”)

•
Shareholder activism played a key role in shaping M&A in 2013
•
Role ranged from instigating (e.g., encourage unsolicited bids) to opposing and/or interrupting deals
•
For example, Dell management buyout (activist Carl Ichan)
–
Resulted in amending deal to decrease break-up fees, increase consideration and change the voting approval threshold for the deal

•
Enhance Deal flow?:
–
More proactive, preemptive activity from target boards re M&A (including spin- offs)
–
M&A considered as part of ongoing strategy assessments—no longer special situations
•
Discourage Deal flow?:
–
Potential acquirer needs to anticipate how acquisition will be viewed by its stockholders
•
This will continue to be an important trend in 2014 and beyond

Special Issues In Controlling Stockholder Deals (and Tips for Private Equity)

Special Issues In Controlling Stockholder Deals
•
Q: What standard of review is generally applied to a board’s actions in the context of an M&A transaction?
•
A: The Business Judgment Rule.
•
Q: What is the Business Judgment Rule?
•
A: The Business Judgment Rule prevents courts from second-guessing the decisions of independent and disinterested directors who have performed their duties (1) in good faith; (2) with the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner the directors reasonably believe to be in the best interests of the corporation.
•
There is not examination of fairness.
•
The burden of proof is on the plaintiff.

•
Business Judgment Rule Applies to Certain Controlling Stockholder Transactions
–
In re MFW Shareholders Litigation, 67 A.3d 496 Del. Ch. May 29, 2013), affirmed Kahn v. M&F Worldwide Corp., No. 334, 2013 (Del. Mar. 14, 2014)
–
MacAndrews and Forbes (“M&F”) was the controlling stockholder (43%) of M&F Worldwide (“MFW”) and offered to purchase the rest of MWF’s outstanding equity for $24 per share.
–
MFW’s shares were trading at $16.96 at the close of the last business day prior to M&F’s offer.
–
Shareholders brought suit challenging the merger alleging that it was unfair and sought a post-closing damages remedy for breach of fiduciary duty.
–
At the outset, M&F conditioned consummating any going-private transaction upon the transaction being approved by (i) an independent special committee and (ii) a vote of a majority of the disinterested stockholders.
–
The Court held that the appropriate standard of review was the business judgment rule and granted judgment in the in favor of the defendants.

•
The Delaware Supreme Court affirmed the Chancery Court’s ruling holding that “business judgment is the standard of review that should govern mergers between a controlling stockholder and its corporate subsidiary where, the merger is conditioned ab initio upon:
–
(1) an independent, adequately empowered special committee that fulfills its duty of care; and
–
(2) the uncoerced, informed vote of a majority of the minority stockholders.
•
The Delaware Supreme Court found that the dual protection merger structure requires two price-related determinations:
–
(1) that a fair price as achieved by an empowered, independent committee that acted with care; and
–
(2) that a fully, informed, uncoerced majority of the minority stockholders voted in favor of the price that was recommended by the independent committee”

Special Issues in Controlling Stockholder Deals
•
Entire Fairness Review Applies to Certain Controlling Stockholder Deals
–
In re Orchard Enterprises, Inc. Stockholder Litigation, C.A. No. 7840 (Del. Ch. Feb. 28, 2014)
–
The controlling stockholder, Dimensional Associates, LLC (“DA”) held 53% of the voting power of Orchard.
–
In October 2009, DA offered to buy out Orchard’s minority stockholders for $1.68 per share in cash.
–
Orchard formed a five-member special committee, which was authorized to negotiate with DA and potential third-party bidders and to hire independent legal and financial advisors.
–
Orchard’s public announcement of DA’s initial proposal led to a higher offer from a third party. DA then offered $2.10 per share without a majority-of-the-minority approval condition, and finally agreed on a price of $2.05 per share with a go- shop and a majority-of-the-minority condition.

•
The financial advisor issued an opinion that the $2.05 per share price was fair from a financial point of view (taking into account that $25 million of the equity value of Orchard would be allocated to the Series A Preferred Stock).
•
Orchard’s proxy statement recommended approval of the merger and in July 2010, holders of a majority of the minority approved the merger.
•
The Court found evidence that the lead special committee director was not independent or disinterested due to long-standing relationships with family members of DA’s founder and the director’s solicitation of a post-closing consulting agreement with DA.
•
The controlling stockholder did not agree up-front that the deal would be conditioned upon either approval by a special committee and a majority vote of the minority stockholders.
•
The Court held that the appropriate standard of review was the entire fairness standard.
•
The Court noted that if the controller agreed to one but not both of the protections, the burden of persuasion may be shifted from the defendants to the plaintiff under the entire fairness standard.

•
Entire Fairness Review May Apply to Private Equity Fund Take-Private
–
Frank v Elgamal, C.A. No. 6120-VCN (Del. Ch. Mar. 10, 2014)
–
Private equity fund Great Point Partners sought to acquire American Surgical Holdings, Inc. The board formed an M&A committee and obtained a financial advisor to solicit offers. Three potential buyers, including Great Point, submitted offers.
–
Special Committee of independent, non-executive directors oversaw the negotiation process for the sale of American Surgical Holdings, Inc. to Great Point.
–
During the course of diligence, accounting problems with the target’s financial statements were identified. Great Point Partners presented the target with three choices with varying mixes of cash and equity to be provided to “rollover stockholders” (management).
–
The option selected by the special committee provided the greatest ratio of cash to equity to the rollover stockholders but provided slightly less overall consideration to the minority stockholders (4 cents per share) than if the rollover stockholders took more equity.

•
Court did not grant summary judgment and noted:
–
a procedural defect (no record in the minutes that special committee was informed of the varying levels of compensation to the minority stockholders) and
–
the management stockholders and minority stockholders had a direct conflict of interest
–
Court concluded that “entire fairness” standard could apply.
–
Key takeaways for Private Equity:
•
Be vigilant about addressing potential conflicts of interests, particularly those presented by insider stockholders (like rollover management).
•
Any option that deprives the minority stockholders with even a few pennies per share can lead to a lawsuit in which the burden lies on the board of directors to prove the merger was entirely fair.

•
The business judgment rule will be applied to a controlling stockholder transaction if and only if:
–
(1) the controller conditions the procession of the transaction on the approval of both a special committee and a majority of the minority;
–
(2) the special committee is independent;
–
(3) the special committee is empowered to freely select its own advisors and to say no definitively;
–
(4) the special committee meets its duty of care in negotiating a fair price;
–
(5) the vote of the minority is informed; and
–
(6) there is no coercion of the minority.
Controlling Stockholder Deals – Key Takeaways

Controlling Stockholder Deals – Key Takeaways
•
If any of the procedural safeguards are not observed, the transaction will be reviewed under the entire fairness standard which requires:
–
(1) Substantive Fairness – price
–
(2) Procedural Fairness – process
•
The defendant typically bears the burden of proving entire fairness. There may be a shift in the burden of proof to the plaintiffs if it can be shown that the transaction was approved by:
–
(1) a well -functioning committee of independent directors; or
–
(2) an informed and uncoerced vote of a majority of the minority

Questions?
Oscar A. David
Chair, Mergers & Acquisitions/ Securities/Corporate Governance
Chicago
(312) 558-5745
odavid@winston.com
Eva Davis
Chair, West Coast Private Equity
Los Angeles
(213) 615-1719
evadavis@winston.com
Robert J. Rawn
Partner, Mergers & Acquisitions/ Securities/Corporate Governance
New York
(212) 294-6721
rrawn@winston.com

Trends and Developments in M&A (Part I): Public Company Targets

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