Merger Litigation Sharply Rejected by the Seventh Circuit

Here is analysis of a new case from Wachtell Lipton: Long after Sam Zell’s decision to sell Equity Office Properties (EOP) at the market top in an all-cash deal was followed by a near-complete collapse of the market for REITs and commercial office space, shareholder plaintiffs continued to pursue litigation claiming that they were ill-served by the transaction.

In a decision of the United States Court of Appeals for the Seventh Circuit issued recently, Judge Richard Posner decisively rejected these claims. The opinion, which primarily affirms the dismissal of claims that EOP’s proxy solicitation was misleading, also touches on the appropriate role that break-up fee arrangements play in merger transactions as a matter of economic logic and fiduciary duty, and reaffirms the limited scope of the judicial process in supervising both the federal proxy rules and state-law fiduciary matters, correctly categorizing the plaintiff’s purpose as seeking to “sink[] the process of corporate acquisition into a sea of molasses.” Beck v. Dobrowski, et al., 2009 WL723172 (7th Cir. March 20, 2009).

The case arose out of Blackstone’s all-cash deal to acquire EOP for $55.50 per share in early 2007. Blackstone clinched the deal only after a protracted bidding battle, and with the protection of a termination fee that was negotiated upwards to $720 million by the time the Blackstone’s prevailing bid was ultimately accepted. The shareholder plaintiff brought suit under §14(a) of the Securities Exchange Act, alleging that the merger proxy should have included additional back-up valuation information and details on the benefits that top EOP executives were to receive in the Blackstone transaction, and complaining generally about the terms of the transaction and the conduct of the sale process. The complaint tacked on supplemental state law claims alleging that EOP’s directors breached their fiduciary duties, notwithstanding that fiduciary duty litigation was already pending in the courts of Maryland, the state of EOP’s incorporation.

The appeals court rejected the plaintiff’s claims. As to the §14(a) claim, Judge Posner confirmed that “the antifraud provisions of the federal securities laws are not a general charter of shareholder protection, which, the court made clear, remains the proper province of state fiduciary duty law. (The court went out of its way, however, to note that the termination fees about which plaintiff complained are “not … generally improper under any body of law with which we are familiar.”)

Then, applying the Supreme Court’s 2007 decision in Bell Atlantic v. Twombly with full force to the merger litigation context, the panel rules that plaintiff’s merger proxy claims “were too feeble to allow the suit to go forward.” The court noted that “there is nothing in the complaint to suggest that any shareholder was misled or was likely to misled,” and no suggestion that any “shareholder drew a wrong inference” from any of the alleged factual omissions. Under Twombly, defendants should not be burdened with the heavy costs of pretrial discovery … unless the complaint indicates that the plaintiff’s case is a substantial one.”

Turning to plaintiff’s supplemental state law claims, the panel struck a blow for judicial efficiency by affirming the district court’s determination to stay the Maryland fiduciary claims. To permit such claims to proceed in federal court while identical claims were pending in state court would allow “different members of what should be a single class [to] file identical suits in federal and state courts to increase their chances of a favorable settlement.”

As Judge Posner observed, “[t]he state-law issues that our plaintiff has presented to the federal court will be definitively resolved by the courts of the state whose law governs these issues, and our court would be required to defer to that resolution because state courts are the authoritative expositors of their own state’s laws.” The court thus resolved the increasingly frequent problem of multi-jurisdiction merger litigation with a bright-line ruling in favor of the courts of the incorporating state.

The Beck decision constitutes a decisive affirmation of the business judgment rule. The complaint failed because “any evidence that the plaintiff would have presented … concerning the optimal strategy for EOP to have pursued would have been heavy on hindsight and speculation, light on verifiable fact.” Such second-guessing of directors remains impermissible in the courts, state or federal, and insufficient to state a claim challenging a merger agreement entered into in good faith.

Game Changer: Delaware Supreme Court Reverses in Lyondell

We have begun posting memos on the Lyondell decision in our "Fiduciary Duties" Practice Area. Even though I blogged about it yesterday, the case is important enough to also blog the following analysis from Travis Laster:

On Wednesday, the Delaware Supreme Court issued this decision reversing Vice Chancellor Noble’s denial of summary judgment in Lyondell. I expect much will be written about this case, because it is a game changer.

In my view, the decision goes a long way towards eliminating the possibility of a loyalty claim for failure to act in good faith where the claim is the directors allegedly “knew” that their fiduciary duties required particular action. It also goes a long way towards eliminating any possibility of a post-closing damages remedy in a Revlon scenario involving independent directors. The major short-term impact of the decision, I believe, will be to shift the focus of parties challenging mergers to the injunction phase, because post-closing challenges will no longer be viable in most instances. It remains to be seen whether Lyondell’s approach to review of a sale process will also permeate the pre-closing world of injunction practice.

Analysis of the Reversed Chancery Court's Decision

The process in Lyondell was the type of CEO-driven affair that Delaware courts have cautioned against since the 1980s. Here is my description on Vice Chancellor Noble’s decision:

“[A] stockholder plaintiff challenged the cash sale of a chemical company to a strategic acquirer at a 45% premium to the unaffected market price. The deal was approved by a board comprised of 10 indisputably independent outsiders and the CEO. Prior to the acquirer filing a 13D, the target was healthy and not in financial distress. It was also not for sale, and the board had not run any type of process or engaged in recent efforts to determine the sale value of the company. The CEO fielded the inquiry and led the negotiations, getting well out in front before bringing the board in, setting the acquirer’s price expectation at $48 per share without board input, and then going to the board for approval and a fairness opinion.

To the CEO’s credit, there was apparently no discussion of his personal situation, and the CEO rebuffed a competing LBO inquiry as presenting too many conflicts. Nevertheless, he was clearly in the lead, and the entire process of board consideration and approval spanned just one week. The merger agreement had standard deal protections, with a no-shop, matching rights, and a break fee equal to 3% of equity value and 2% of enterprise value. There was no post-agreement go shop, just the inherent market check that accompanies any announced deal with this combination of provisions.”

On these facts, Vice Chancellor Noble denied the defendants’ motion for summary judgment, finding that the lack of involvement by the Board and the CEO-driven process gave rise, at the summary judgment stage, to a permissible inference of bad faith. He therefore denied summary judgment, while signaling strongly that the directors would prevail on the merits at trial.

The Delaware Supreme Court accepted a rare interlocutory appeal from this decision and reversed.

Analysis of the Supreme Court's Decision

Because Lyondell had a 102(b)(7) provision and a majority-independent board, the Supreme Court held that the directors only could face liability if they acted in bad faith by “knowingly and completely failed to undertake their responsibilities.” (18). Accordingly, the Supreme Court held that “the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.” (19). In holding that the directors satisfied this standard, the Court assumed “that the Lyondell directors did absolutely nothing to prepare for Basell’s offer, and that they did not even consider conducting a market check before agreeing to the merger.” (19).

Compare this language with prior Supreme Court decisions, which taught that a “board of directors . . . may not avoid its active and direct duty of oversight in a matter as significant as the sale of corporate control.” Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261, 1281 (Del. 1988). A similar lesson was that “directors cannot be passive instrumentalities during merger proceedings.” Citron v. Fairchild Camera and Instrument Corp., 569 A.2d 53, 66 (Del. 1989). They were told to provide “serious oversight,” Mills, 559 A.2d at 1265, and that their fiduciary duties required that they “take an active and direct role in the context of a sale of a company from beginning to end.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 367 (Del. 1993). These obligations were not limited to management buyouts or conflict situations but rather applied to all potential change of control transactions. Paramount Comm., Inc. v. QVC Network, Inc., 637 A.2d 34, 44 (Del. 1994). Ultimately, under QVC, the directors had the burden of proof to establish that they acted reasonably to obtain the best transaction reasonably available. Id.

The language of Lyondell suggests a different approach to judicial review of a sale process. While anything is theoretically possible, it is difficult for me to imagine the case where independent directors will have “utterly failed to attempt to obtain the best price” or “knowingly and completely failed to undertake their responsibilities.” My takeaway from Lyondell is that a majority-outsider board no longer faces post-closing litigation risk for a Revlon sale but rather can rely on summary judgment plus a 102(b)(7) provision to eliminate the case. This in turn has major and readily apparent implications for case strategy and settlement leverage.

Because Lyondell is a post-closing damages case, it is possible to view its language as limited solely to that context. Under that reading, the old learning, burdens of proof, and standard from QVC would continue to apply in the injunction context. If so, then the logical move for plaintiffs is to shift their focus entirely to injunction practice, because post-closing there will not be anything meaningful to litigate. In this regard, Lyondell echoes Chancellor Chandler’s decision grant of summary judgment in In re Transkaryotic Therapies, which implied a similar fate for post-closing damages litigation based on disclosure violations.

But if the lesson for plaintiffs from Lyondell is that the injunction is everything, then even that might not be much. Recent decisions like Netsmart and Lear suggest that plaintiffs will not have much success obtaining deal-process injunctions in the absence of a topping bid. The Court of Chancery has tended towards granting disclosure-based injunctions, including disclosures about the sale process, but otherwise allowing stockholders to decide for themselves whether to accept a premium bid. Plaintiffs thus may not fare any better in the pre-closing injunction context, and the focus will likely be primarily on disclosures.

Opining on a Limited Record

An equally problematic issue for plaintiffs is that the Supreme Court questioned in Lyondell whether the directors so much as breached their duty of care, observing “even on this limited record, we would be inclined to hold otherwise.” (17). In that regard, the facts of Lyondell are worth repeating. The CEO ran the process and was well out in front of the Board. The directors did not gather information about the value of the transaction or probe the market for competing offers. They were, in the Supreme Court’s words, “generally aware of the company’s value and its prospects.”

Their financial advisor, Deutsche Bank, was not hired until after the price was established and was charged only with preparing a fairness opinion. Deutsche Bank thus did not have any significant involvement in the negotiations over price or structure. Nor did Deutsche Bank or any other financial advisor play a role in structuring the process. And although Deutsche Bank compiled a list of potential acquirers, they were instructed not to solicit any competing offers for the company. The Board considered the Basell proposal for about 50 minutes on July 10, then discussed the proposal for approximately 45 minutes on July 11. The Board met again on July 12 and discussed the Basell proposal in executive session without management present. On July 16, the Board approved the transaction.

This was a minimalist process. Yet the Supreme Court indicated that it would not give rise to a care violation. With Lyondell as a guidepost, future plaintiffs will have difficulty establishing a reasonable probability of success on the merits of a care claim that would support the issuance of an injunction. And deal counsel (including Delaware counsel) will have difficulty advising clients that what they want to do is unlikely to pass muster. Director conflicts of interest and conflict transactions will still require careful review and nuanced advice, but Lyondell signals a largely unlimited range of action for independent boards, with market forces as the primary check and fiduciary duty review playing a lesser role.

Although these factors alone would make Lyondell a game-changing case, the decision then goes further in its analysis of good faith by noting that “there are no legally prescribed steps that directors must follow to satisfy their Revlon duties. Thus, the directors’ failure to take any specific steps during the sale process could not have demonstrated a conscious disregard of their duties. More importantly, there is a vast difference between an inadequate or flawed effort to carry of fiduciary duties and a conscious disregard for those duties.” (18)

To my mind, the softness of fiduciary duty analysis is not limited to the Revlon context. Compliance with fiduciary duties is always context-specific. It does not require pre-ordained steps, but rather the exercise of judgment. Lyondell suggests to me that while there remains room for a bad faith breach where clear statutes or regulatory requirements are concerned, there is not much room, if any, under Delaware law for a claim for bad faith breach based on failure to comply with fiduciary duties.

Thoughts on Section 102(b)(7)

A final thought on Lyondell concerns the mid-discovery, pre-trial invocation of Section 102(b)(7). In Emerald Partners v. Berlin, 725 A.2d 1215 (Del. 1999), the Delaware Supreme Court held that a Section 102(b)(7) provision could not be invoked prior to trial in an entire fairness case because the defendants had the burden of proof and it was not possible to determine, prior to trial, whether the directors’ breaches implicated the duty of loyalty or the duty of care. This contrasted with cases asserting only a breach of the duty of care, where a Section 102(b)(7) provision could be invoked routinely at the motion to dismiss stage to result in dismissal.

After Emerald Partners, it was possible that the Supreme Court would apply the same rationale to other scenarios, such as Revlon/QVC and Unocal, where the directors bore the burden of proof and where a fiduciary breach could implicate either loyalty or care. Lyondell makes no mention of Emerald Partners and the Supreme Court had no difficulty entering summary judgment for the defendants. After Lyondell, it seems clear that the Emerald Partners limitation on invoking a Section 102(b)(7) provision prior to trial applies only in cases where entire fairness applies “ab initio,” such as controlling stockholder transactions, and will not have any application in other contexts.

The underlying sense of a retreat from enhanced scrutiny under Revlon/QVC towards business judgment review in Lyondell echoes a similar approach in the recent Gantler decision, in which passages appeared to retreat from Unocal review. Lyondell and Gantler likewise both avoid mentioning any shift in the burden of proof to the director defendants, which traditionally was a hallmark of both the Revlon/QVC and Unocal frameworks.

Together, Gantler and Lyondell underscore Delaware’s continued faith in and deference to decisions made by independent directors. If anything, and consistent with Delaware’s director-centric model, the degree of deference appears to be on the upswing. For independent directors and their counsel, this is a good thing.

The Big Reversal: Lyondell Chemical Company v. Ryan

- by Brad Aronstam, Connolly Bove Lodge & Hutz

Last night, the Delaware Supreme Court delivered the much anticipated decision in Lyondell Chemical Company v. Ryan (No. 401, 2008). The decision reverses last year's widely-followed opinion of the Court of Chancery declining to grant summary judgment in favor of the defendant directors of Lyondell Chemical Company ("Lyondell") on Revlon claims.

Having taken the rare action of granting defendants' interlocutory appeal from a decision denying summary judgment, the Delaware Supreme Court took the even rarer action of not only reversing the Court of Chancery but also entering summary judgment in favor of the defendant directors. In so doing, the Supreme Court with surprising terseness decided what apparently is a novel issue of Delaware law: precisely when Revlon duties arise.

As set forth by the Supreme Court, Revlon duties arise not when a company is put in play (such as in the case of Ryan when a Schedule 13D puts a company in play), but "when a company embarks on a transaction - on its own initiative or in response to an unsolicited offer - that will result in a change of control." Here, the Supreme Court held that Revlon duties did not arise until the target directors actually began negotiating the sale of Lyondell. Rather, the decision to "wait and see" was subject to the deferential business judgment rule.

The Supreme Court moreover directed the focus of any relevant inquiry on the affirmative actions of the directions (i.e., what the directors did do), as opposed to what they did not do. Ultimately, the Supreme Court admonished: "[t]he trial court approached the record from the wrong perspective. Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price."

The particular factual allegations underlying this decision bear emphasis and provide transparency into where the Supreme Court was coming from: the consideration paid to Lyondell stockholders represented a 45% premium over the closing stock price of Lyondell immediately before the market learned of the would-be acquirer's interest in Lyondell from the above referenced Schedule 13D; the transaction was approved by an independent and disinterested board; and the merger was additionally approved by 99.33% of the shares voting in favor of the transaction (equal to 65.80% of the total outstanding shares).

The merger transaction thus represented a substantial premium, lacked any of the hallmark conflicted director/shareholder suitors that typically predominate these types of challenged transactions, and garnered the resounding endorsement of the Lyondell shareholders.

At the end of the day, the Court's outcome is not altogether surprising given this confluence of unusual facts and the decision to grant interlocutory appeal in the first place. The short 20-page opinion is a "must read" for M&A practitioners and surely will serve as fodder for much discussion and debate in the months to come.

Analysis: Flip-In vs. Flip-Over Pills

- by John Jenkins, Calfee Halter & Griswold

A member recently asked in the DealLawyers.com "Q&A Forum" about the rationale for including “flip-in” and “flip-over” provisions in shareholder rights plans, or “poison pills.” When a company adopts a rights plan, it typically issues of a right to purchase a fraction of a share of preferred stock as a dividend to all of the issuing company’s shareholders. The exercise price of the rights is usually based on an assessment of the price that it would be reasonable to expect the stock to achieve over the life of the rights plan. Frequently, the board receives input from a financial advisor in setting the exercise price of the rights at the time they are issued.

These rights do not become exercisable until a raider acquires beneficial ownership of a specified percentage of the target’s outstanding shares. (That percentage is usually between 10% and 20% of the outstanding shares, but in the case of NOL pills, it is typically set at 4.9 %.). When a raider crosses that threshold, the rights detach and become exercisable -- except for those rights that are held by the raider, which when you get right down to it is what makes pills work in the first place.

Rights plans typically include both “flip-in” and “flip-over” features. The plan’s “flip-in” feature comes into play when a raider triggers the rights plan by acquiring the percentage of the target’s common stock specified in the plan. When this happens, each right then outstanding (other than those held by the buyer) "flips-in" and gives each holder the right to purchase shares of the target’s common stock with a market value equal to twice the exercise price of the right.

What a flip-in provision does is deter the buyer from crossing the ownership threshold that will trigger the rights plan by confronting it with the prospect of substantial dilution. Since every holder except the buyer will be able to purchase new shares at a 50% discount to current market, the buyer’s ownership interest will be diluted if the flip-in provision of the rights plan kicks in. The actual amount of that dilution will depend on the exercise price of the rights, but it is almost invariably going to be quite substantial - substantial enough to make triggering the rights economically unviable.

A “flip-over” feature is intended to protect against a second step transaction. The flip-over provision would come into play if, after the rights have been triggered, the target was sold or engaged in some other change in control transaction. Under those circumstances, each right then outstanding would "flip over" and become a right to buy shares of the raider’s common stock with a market value equal to twice the exercise price of the right.

Like the flip-in provision, the deterrent effect of the flip-over provision depends on its dilutive effect on ownership interests. However, in contrast to the flip-in provision, which dilutes the buyer’s interest in the target company, the flip-over provision dilutes the interest of the buyer’s shareholders in the buyer itself.

Testing the Chinese Anti-Monopoly Law: China Blocks Foreign Acquisition of Chinese Company

Last week, the Ministry of Commerce of the People's Republic of China blocked Coca-Cola's proposed acquisition of a major domestic juice manufacturer (China Huiyuan Juice Group Limited) under a recently enacted Anti-Monopoly Law. This is the Ministry's first significant decision applying the AML to a foreign acquisition of a domestic Chinese firm.

The Ministry of Commerce concluded that the acquisition would adversely affect competition in - and the development of - the Chinese juice beverage market. In particular, the Ministry raised concerns that, as a result of Coca-Cola's strength in the carbonated beverage sector, the transaction could give rise to potential anticompetitive effects from bundling and tying practices.

Although it's too early to predict with much certainty - since this case was complicated - this decision points to the possibility that the Ministry may be more protective of the independence of Chinese companies compared to other antitrust authorities around the world. We have posted memos regarding this decision in our "Antitrust" Practice Area.

FASB Amends Guidance on Standard for Contingencies in Business Combinations

Last Friday, the FASB held a roundtable to discuss disclosure of certain loss contingencies. This handout shows the issues that were discussed, as the FASB is redeliberating last year's proposed revisions to FAS 5 and FAS 141(R).

Among others, the issues in this redeliberation have implications for the "Treaty" between the ABA and the AICPA on lawyers' responses to auditors' requests for information on pending and threatened litigation and unasserted claims under FAS 5. Here are notes from the roundtable from Sanford Lewis. Any day now, it is expected that the FASB will issue a FASB Staff Position on FAS 141(R) on these issues in connection with business combinations since the FASB voted to do so at the end of February.

Below is a summary of what we can expect from Wilmer Hale:

In amending SFAS 141R, the FASB decided to "carry forward" the prior standard for recognition of contingencies under FASB Statement No. 141, Business Combinations (SFAS 141). Companies will now be required to recognize assets acquired and liabilities assumed in a business combination that arise from contingencies at fair value, if fair value can be reasonably estimated. If fair value of such an asset or liability cannot be reasonably estimated, the asset or liability would be recognized in accordance with FASB Statement No. 5, Accounting for Contingencies (SFAS 5), and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss. It is expected that most litigation contingencies assumed in an acquisition will be recognized only if a loss is probable and the amount of the loss can be reasonably estimated.

Last year, the FASB proposed the FSP in response to concerns about various provisions of SFAS 141R applicable to contingencies. Members of the legal community expressed concerns about the standards as they applied to litigation contingencies, in particular, the requirements that contingencies be recognized at their acquisition-date fair value if it was "more likely than not" that a loss had occurred. The FASB's proposed FSP would have largely reinstated the prior standard for recognition under SFAS 141, but with amplifications and changes to other aspects of the standard. At its February meeting, the FASB decided to carry forward SFAS 141 without significant revision, thereby leaving many of the issues considered in the proposed FSP for another day.

The FASB also amended the disclosure requirements in SFAS 141R to eliminate the requirement to disclose an estimate of the range of outcomes of recognized contingencies at the acquisition date. For unrecognized contingencies, the FASB will require only that entities include the disclosures required by SFAS 5 and that those disclosures be included in the business combination footnote.

The FSP will have the same effective date as SFAS 141R, and therefore will be effective for all business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 (January 1, 2009, for calendar year-end companies).

The FASB plans to issue the final FSP in March 2009. Companies that have closed or expect to close business combinations in the first quarter of 2009 should pay careful attention to the impact of the amended standard on contingencies that may be acquired or assumed in the transaction.

The SEC Staff on M&A

Tune in tomorrow for this webcast - “The SEC Staff on M&A” - to hear all the latest from:

- Michele Anderson, Chief, SEC's Office of Mergers & Acquisitions
- Dennis Garris, Partner, Alston & Bird LLP and former Chief, SEC’s Office of Mergers & Acquisitions
- Jim Moloney, Partner, Gibson Dunn & Crutcher LLP and former Special Counsel, SEC’s Office of Mergers & Acquisitions

And stay tuned for this webcast: "Deal Protection: The Latest Developments in an Economic Tsunami."

March-April Issue: Deal Lawyers Print Newsletter

This March-April issue of the Deal Lawyers print newsletter was just sent to the printer and includes articles on:

- Lessons from the Meltdown: Remedies
- Poison in a Pen: Recent Trends in Drafting Shareholder Rights Plans
- The Ultimate Takeover Defense? RiskMetrics’ New View on Net Operating Loss Poison Pills
- Delaware Upholds Private Equity Deal Structures
- Recent Developments under the Delaware Short-Form Merger Statute
- Section 13(d): The Challenges of “Group Membership”

If you're not yet a subscriber, try a 2009 no-risk trial to get a non-blurred version of this issue for free.

“You’re Going the Wrong Way!”

- by John Jenkins, Calfee Halter & Griswold

Remember the scene in "Planes, Trains and Automobiles" where John Candy and Steve Martin are driving the wrong way down an interstate highway? A couple driving in the adjacent lane roll down their window and repeatedly scream “you’re going the wrong way!!” in an effort to get them to turn around. Candy and Martin ignore their warnings, only to eventually look up and see two semi-trucks bearing down on them at high speed. Hilarity ensues.

I am frequently reminded of this scene when I look at the initial draft of a merger agreement for a taxable acquisition and find the deal structured as a forward subsidiary merger (i.e., one in which the target merges into the buyer’s merger sub, with merger sub as the surviving corporation). I’m sure there may be some tax or non-tax reasons to structure a taxable transaction in this manner from time to time, but a forward merger usually is not the preferred way to structure a taxable corporate acquisition. In fact, it is usually the worst possible structure for such a transaction.

That’s because - in the strange universe presided over by the IRS - there are no such things as taxable “mergers.” There are taxable stock acquisitions, and taxable asset acquisitions. If the IRS thinks your deal looks like a taxable asset acquisition, you get hit with double taxation (gain is taxed at the corporate and shareholder level).

For the past 40 years, the IRS has taken the position that a forward merger is an asset acquisition subject to double taxation. (If you’re interested, the pertinent authority is Rev. Rul. 69-6, 1969-1 C.B. 104). In contrast, a reverse subsidiary merger (i.e., one in which merger sub is merged into the target, with the target surviving) is treated as a stock acquisition. This is the classic trap for the unwary - and some scholars have argued that the IRS should do away with distinction between forward and reverse mergers, and treat all cash mergers as stock purchases.

It should be noted that when you’re dealing with a tax-free reorganization under Section 368 of the Internal Revenue Code, forward mergers frequently make quite a bit of sense, particularly because you can issue a lot more cash or other non-stock consideration in these transactions than you can in tax-free reverse subsidiary merger.

Putting aside the tax issues, a reverse subsidiary merger structure is often preferable to a forward merger because this structure tends to trigger a lot fewer change of control clauses and consent requirements than does a forward merger structure. Yet despite these tax and non-tax considerations, it’s remarkable how frequently the first draft of deal documents contemplates a forward merger.

Going the wrong way was pretty funny when John Candy and Steve Martin did it, but it’s a lot less amusing if the parties to a merger agreement for a taxable deal do it.

Customary M&A Indemnity Provision Gives Rise to Breach of Loyalty Claim

- by John Jenkins, Calfee Halter & Griswold

Public company merger agreements frequently contain provisions under which a buyer agrees to cause the surviving corporation to indemnify the seller’s directors to the same extent that they are currently indemnified “or to the fullest extent permitted by law.” While this is pretty standard practice, language like this can provide a seller’s directors with much broader indemnity rights than they would be able to obtain from the seller itself. That is usually good news for a seller’s board, but not always.

That point was brought home last month when a Tennessee appellate court, applying Delaware law, refused to dismiss duty of loyalty claims against a seller’s directors premised on the inclusion of customary director indemnity arrangements in a merger agreement.

In Indiana State District Council of Laborers v. Brukardt, No. M2007-02271-COA-R3-CV (Tenn. App. Feb. 17, 2009) the Tennessee Court of Appeals overruled a trial court’s dismissal of a shareholder class action lawsuit against the board of directors of Renal Care, Inc., a health care company that was acquired by Fresenius Medical Care AG in 2005. Among their other allegations, the plaintiffs contended that the defendants breached their fiduciary duty of loyalty by entering into the merger in order to “cover alleged Medicare fraud and back dating of stock options, [and] also to insure that they would be free of any possible liability for such acts.”

In dismissing the plaintiffs’ loyalty claim, the trial court held that a majority of the Board had no conflicts of interests. The appellate court disagreed, noting that the plaintiffs had alleged that “by engineering the merger which included indemnification, all defendants were able to significantly minimize their exposure to liability in connection with the alleged brewing problems at Renal Care.”

The defendants contended that no conflict of interest existed between the interests of directors and shareholders when the indemnity rights given them under the merger agreement were “essentially duplicative” of rights that they already had, but the court disagreed:

“First as a matter of Delaware law, Renal Care could only indemnify defendants for “acts in good faith and in the best interests of the corporation.”But Fresenius, as a third party indemnifying Renal Care directors, is not bound by “the restrictions of statutory corporate law” and can extend indemnifications to defendants for breaches of the duty of loyalty and good faith.”

In reaching this conclusion, the court cited the Delaware chancery court’s decision in Louisiana Mun. Police Employee's Ret. Sys. v. Crawford, 918 A.2d 1172, 1180 n. 8 (Del. Ch. 2007). In that case, the chancery court characterized the distinction between the indemnification that a buyer could provide and that which the seller could provide its own directors as being “quietly critical.” In the present situation, the court believed that under Delaware law, “the indemnification offered by Fresenius covers defendants' liability for option backdating, a breach of the duty of good faith, whereas the indemnification offered to defendants by Renal Care could not.”

Crawford involved the CVS/Caremark transaction and attracted a lot of attention when it was decided. At the time, most of the discussion surrounded the court’s decision that Caremark’s shareholders had appraisal rights in a purported stock-for-stock merger because a special dividend declared in connection with transaction should be considered part of the merger consideration.

The Chancery Court’s discussion of the distinction between the rights to indemnity that a director could obtain from his or her corporation and those that a buyer could provide was confined to a footnote. Nevertheless, as the Tennessee Court of Appeals decision in Laborers v. Brukardt suggests, that footnote may have some pretty important implications for those involved in mergers and acquisitions.

A Little Comic Relief

Oddly, I've been watching a few of CNBC's stock market shows lately. I guess I've been curious how they've been touting stocks in this downturn and it's been comic relief. And the recent feud between Jon Stewart and Jim Cramer has been absolutely hilarous - and coming to a head tomorrow when Jim appears on "The Daily Show."

One of the delightful surprises was catching one of my DealLawyers.com advisors, Frank Aquila of Sullivan & Cromwell, on "Fast Money" Monday night (here is a video archive of it). Apparently Frank is a regular guest and he was great riffing on the state of M&A.

His shining moment was dealing with one of the host's awkward statements that more deals tended to happen during the proxy season as she seemed to be confused about cause and effect. Frank didn't show her up for her inartful statement (she probably meant that if companies were going to run slates they would have to be going forward right now).

Anyways, I think I've gotten CNBC out of my system. Fun while it lasted...

The "Deal Cube" Chronicles: Part 2

Following up on my earlier blog portraying some "deal cube" chronicles, I'm holding a contest for the coolest cube. Please email me pictures of the cube(s) that you cherish the most. If you wish to remain anonymous, I'll honor that request as always.

Here are a few more deal toy stories:

- We did a public offering of subordinated debt a number of years back. There was an extensive negotiation with the senior lender regarding the subordination agreement and specifically on the "fish or cut bait" provisions which force the senior lender to exercise remedies or free the subordinated debt holders to exercise their remedies. The cube for the deal was the bones of a fish.

The underwriter only provided one such cube to one of the lawyers in my firm who worked on the deal. Over the next ten years, the cube was stolen from the office of the receiving lawyer multiple times by the other lawyers in the firm who worked on the deal and hidden away, but subsequently retrieved. Eventually, he brought the cube home only to have it stolen again at a firm party that he threw at his house.

- I have a cube from a deal I did about five or six years ago that looks like a miniature suitcase nuke. Some poor junior banker had to carry these things through airports on his way to the closing dinner. It’s a miracle he didn’t end up in Guantanamo in the cell next to "Harold and Kumar."

More to come. Keep those deal cube stories coming...

Valuing Interests in Private Equity and Hedge Funds

In our "Private Equity" Practice Area, we have posted a number of memos and articles discussing the future of the private equity and hedge fund industries. One of the articles states:

"In fact, new research from The Boston Consulting Group and the IESE Business School indicates that at least 20 percent of the 100 largest leveraged-buyout private equity firms - and possibly as many as 40 percent - could go out of business within two to three years. More disturbingly, most private equity firms' portfolio companies are expected to default on their debts, which are estimated at about $1 trillion."

Carbon Risks and Opportunities: Implications for Investment Activity and M&A

My guess is that this will be the year that law firms start catching up in the digital world. For example, Torys has started doing podcasts, including this podcast entitled "Carbon Risks and Opportunities: Implications for Investment Activity and M&A."

Developments in Debt Restructurings & Debt Tender/Exchange Offers

We have posted the transcript for the webcast: "Developments in Debt Restructurings & Debt Tender/Exchange Offers."

More on Roche and Genentech's Tangled Web

- by Kevin Miller, Alston & Bird

As a follow-up to the excellent piece by John Jenkins, I thought the following point worth noting:

Under Pure Resources, any shareholder of Genentech should be able to get Roche's tender offer enjoined until Genentech publicly discloses a summary of the financial analyses of Goldman Sachs underlying Goldman Sach's inadequacy opinion on which the Genentech special committee relied in recommending that shareholders not tender their shares into the Roche offer.

That result was intended by the Pure Resources court to force the Pure Resources special committee to disclose the valuation ranges indicated by its financial advisors' analyses so that shareholders could make an independent decision based on that analysis whether to tender or not. The Pure Resources court argued that because the special committee failed to obtain the right to implement a poison pill (just imagine the likelihood that Roche's representatives on the Genentech board would authorize an independent special committee of Genentech directors to implement a pill), the special committee had no negotiating leverage and forcing the special committee to disclose its reserve price would not have adverse consequences, as shareholders were being left to their own devices and it was their reserve price that mattered.

The Pure Resources court's ruling was problematic for a number of reasons including, among other things, that the court, rather than mandating that the special committee disclose a summary of its financial advisors' valuation analyses, enjoined the offer, essentially playing into the hands of a spec. comm. recommending against the offer by giving them the ultimate defensive device, a judicial injunction.

So long as the Genentech special committee is not satisfied with the price offered by Roche, it should refuse to disclose a summary of GS's financial analyses and welcome shareholder suits seeking to enjoin the offer on the basis of inadequate disclosure. For additional - and more detailed - criticisms of the Pure Resources decision, see my article.

The "Deal Cube" Chronicles

Recently, I blogged about the potential demise of the deal cubes and asked people for their stories (as well as conducted a deal toy poll, which is still ongoing if you want to vote). My own tale to tell is a woman I know who took a bunch of cubes to tile her bathroom walls. It actually looked pretty cool.

Here is a story from Bob Dow of Arnall Golden Gregory: As an associate in 1995 worked on an IPO for Moovies, a video chain, sort of mini-Blockbuster. Interesting deal cube, actually it was shaped like an old fashioned movie reel. Only the problem was, of course, even in 1995 no one was still handling the old reel-to-reel movies anymore, they were all video tapes. Fortunately when we did the secondary the next year, the underwriters (Needham) updated and gave us a deal toy in the shape of a VCR tape.

Here are some thoughts from a member who wished to remain anonymous: When I was a new associate, it was nice to receive one at the conclusion of a deal. Whatever it looked like (whether it had moving parts or just a tombstone in lucite), it felt good (to believe) that I was being acknowledged (by the powers that be) as a contributor to the team that closed the deal.

For me, after receiving a number of deal toys, the desire to receive more quickly vanished. Although a number of the toys were quite a novelty, they took up precious space in my office that was better served more practically. I'd much rather occupy the space with good precedent documents, and even better, receive leather bound volumes (another practice that has ebbed) for the transaction documents, which I could refer to for precedents. [Of course today, we can keep thousands of precedents on a thumb drive.]

Today, junior associates are still fascinated by deal toys - like opening presents on Christmas Day. It's a subject of conversation with their fellow associates, and even a perceived badge of achievement. What I believe they really want is some recognition - from the partner or client - as being part of the team and for a job well done. Cubes seem a less than satisfactory method of serving this function (but maybe no different that a retirement watch). Closing dinners are a bit better but practically more difficult to organize (and certainly more costly).

Partners have even more deal toys in their offices - some collected since their first year as an associate (carried with them as a lateral from another firm). It serves a purpose for the partners: reminding them of their past conquests (when they were younger); reminding other people (including clients and potential clients) that "you've stepped into the office of a 'dealmaker'; giving associates something to look at or play with while waiting for the partner to get off the phone; and giving employment to the evening cleaning crew to keep the dust off the deal toys (but pity them if they break a piece and raise the ire of the partner).

There will be more "deal cube chronicles" soon. Keep the stories coming. I'll keep your identity anonymous if you wish...

Madden v. Cowen & Co.: SLUSA’s “Delaware Carve-Out” Applies to Suit Against M&A Financial Adviser

- by John Jenkins, Calfee Halter & Griswold

In Madden v. Cowen & Co. (C.A.9 (Cal.)) (2/11/09), the Ninth Circuit held the “Delaware carve out” contained in the Securities Litigation Uniform Standards Act of 1998 applied to disclosure claims brought against an investment banking firm that rendered a fairness opinion to the board of a seller’s subsidiary in connection with a merger transaction. The case appears to be the first in which a court has extended the Delaware carve-out to shareholder claims made against persons other than officers or directors of the company in which they owned stock.

SLUSA preempts certain state-law based securities fraud class actions involving “covered securities” under the Private Securities Litigation Reform Act of 1995. Before SLUSA’s enactment, plaintiffs had used state-law based class actions to avoid the heightened pleading requirements and other procedural impediments imposed on federal securities class actions by the PSLRA. Under SLUSA, federal claims are generally the only ones permitted to be made for class actions involving securities traded on a national securities exchange, and federal court is the only forum in which those claims may be brought.

SLUSA contains several important exceptions to its preemption of state law shareholder class actions. These include derivative actions and actions based on the law of the issuer’s state of incorporation. These two exceptions have come to be known as the Delaware carve-out. In order for a non-derivative claim to fall within the scope of the Delaware carve-out, it must involve either:

- the purchase or sale of securities by the issuer or an affiliate of the issuer exclusively from or to holders of equity securities of the issuer; or

- a recommendation, position, or other communication with respect to the sale of the issuer’s securities that is made by or on behalf of the issuer or its affiliate to equity holders, and concerns the equity holders’ decisions with respect to voting their securities, responding to a tender or exchange offer, or exercising dissenters’ or appraisal rights.

The second bulleted exception has been used to preserve state law fiduciary duty of disclosure-based claims against directors. See, e.g, Alessi v. Beracha, 244 F. Supp. 2d 354 (D. Del. 2003). However, courts have traditionally declined to extend the carve-out for disclosures made “by or on behalf of an issuer” to disclosure based claims involving communications from persons other than the corporation or its officers and directors. See e.g. Greaves v. McAuley, 264 F. Supp. 2d 1078, 1083-84 (N.D. Ga. 2003) (holding that fiduciary duty claims by former shareholders against the company and its board members were covered by the Delaware carve-out but that claims against the buyer were not).

In Madden, the Ninth circuit rejected contentions by the investment bank that its communications were not made “on behalf of” the issuer. In making this argument, the bank pointed out that it did not serve as the financial adviser to the company in which the plaintiffs were shareholders. Instead, the bank was retained to render a fairness opinion to the board of directors of that company’s majority-owned subsidiary.

Nevertheless, the court noted that the complaint alleged that investment bank’s fairness opinion “was provided to the shareholders of St. Joseph with Cowen's consent and that the shareholders relied on the opinion when voting in favor of the merger.” Accordingly, the court held that the complaint sufficiently alleged that the bank’s communication was “on behalf of” St. Joseph for purposes of the Delaware carve-out, regardless of whether Cowen addressed its letter only to the subsidiary’s board.