January 26, 2011

VC Laster Occam’s Ruling Could Significantly Alter When Revlon Rules Apply

In a hearing on Monday, upon motion to preliminarily enjoin the acquisition of Occam Networks by Calix, Delaware Vice Chancellor Travis Laster made a number of significant rulings in Steinhardt v. Occam Networks (Del. Ch. Ct.; 1/24/11) , including a ruling that could significantly alter the parameters of when the enhanced scrutiny (application of the Revlon rules generally requiring a board to seek the best price reasonably available) rather than the presumption of the business judgment rule will apply to a stock and cash merger.

According to the September 16th press release of the parties announcing the transaction:

Calix [will] acquire Occam Networks in a stock and cash transaction valued at approximately $171 million, which is approximately $7.75 per outstanding share of Occam Networks stock. . . . each outstanding share of Occam Networks common stock (other than those shares with respect to which appraisal rights are available, properly exercised and not withdrawn) will be converted into the right to receive (a) $3.8337 per share in cash, without interest plus (b) 0.2925 of a validly issued, fully paid and non-assessable share of Calix common stock. After the completion of the acquisition, former Occam Networks stockholders will own between 16.5 percent and 18.9 percent of the outstanding shares of Calix’s common stock based on the number of Calix shares outstanding as of September 15, 2010″ Other published reports noted that the $7.75 per share in consideration represented a 27% premium to the share price of Occam stock prior to the announcement of the transaction.

In this transcript of the hearing, VC Laster suggests that a transaction in which the target stockholders will only own approximately 15% of the acquiror after giving effect to the transaction is a “final stage transaction” requiring the application of enhanced scrutiny (i.e., the Revlon rules) rather than the presumption of the business judgment rule:

“This is a deal where the consideration was approximately 50 percent cash floating based on the market price. It was priced as up to 19.9 percent of the acquirer’s share plus enough cash to make the total value number. But the problem is it actually doesn’t receive the 19.9 because of their employee options and awards that are rolling, and so the public will end up holding approximately 15 percent of the post-transaction entity after the fact.

We tend to focus, in our juris prudence, on change of control and the change of control test. So there was a lot of debate over whether this, in fact, was sufficient cash to merit a change of control. I think what people need to remember is that the change of control test is ultimately a derivative test. The point is that when enhanced scrutiny applies is when you have a final stage transaction. The reason enhanced scrutiny applies to a change of control is because it’s a constructive final stage transaction. You’re giving up control to a person who could then cash you out because he’s the new controller. This is a situation where the target stockholders are in the end stage in terms of their interest in Occam. This is the only chance they have to have their fiduciaries bargain for a premium for their shares as the holders of equity interests in that entity.

It’s easy to see here in two ways. First, it’s easy to see in terms of the amount of cash. If you want more cash for your shares, this is the only time you have to get it. But it’s also easy to see in terms of the amount of interest you’re going to have in the post-transaction entity. We often talk about, oh, well, but the stockholders can get a future control premium. That’s all well and good for the future entity, but what you’re bargaining over now is how much of that future premium you’re going to get.

So let’s say that Calix is some day sold, and let’s all hope that it does very well and becomes an attractive acquisition target, and that one of the big boys picks it up at some point for a healthy premium. The target stockholders today are bargaining for what their share of that premium will be. They’re going to only get 15 percent, and obviously there could be more acquisitions that dilute everybody, et cetera. I get that. But as between the Calix stockholders and the Occam stockholders, now is the time; when the target fiduciaries are bargaining for how much of that future control premium their folks will get. This is it. This is the end. This is the only opportunity where you can depend upon your fiduciaries to maximize your share of that value.

I think back in 1989, it made sense for people to be worried over the line between Revlon and non-Revlon. It was three years after that landmark case. That case was a Cunian[sic] paradigm shift if there ever was one. We had language in there like “auction duty, radically altered state,” really seemingly heavy duty stuff. We now know it’s a reasonableness standard. There’s no single blueprint. A target board doesn’t have to take the facially higher cash price. It can consider the strength of the currency. It can take a stock deal if it believes that the stock offers better long-term appreciation and more potential synergies.

That’s why I said at the outset in this case it’s just not worth having the dance on the head of a pin as to whether it’s 49 percent cash or percent cash or where the line is. This is the only chance that Occam stockholders have to extract a premium, both in the sense of maximizing cash now, and in the sense of maximizing their relative share of the future entity’s control premium. This is it. So I think it makes complete sense that you would apply a reasonableness review, enhanced scrutiny to this type of transaction.”

The Occam ruling appears to imply that because Occam stockholders will only own 15% of Calix after giving effect to the transaction, they are less likely to get a significant premium if Calix is subsequently acquired, even though Calix does not appear to have a controlling stockholder or group of stockholders.

Historically, the courts and most practitioners have focused on the percentage of the consideration being paid in cash v. the percentage being paid in stock – i.e., the greater the percentage of the consideration paid in stock, the greater the likelihood that target stockholders will be able to obtain a significant premium in a subsequent transaction in addition to the premium, if any, received in the initial transaction. See footnote 27 in Lawrence Hamermesh’s UPenn Law Review article “Premiums in Stock-for-Stock Mergers and Some Consequences in the Law of Director Fiduciary Duties” that says:

See In re Santa Fe Pac. Corp. S’holder Litig., 669 A.2d 59, 70-71 (Del. 1995) holding that a transaction in which thirty-three percent of the company’s shares were acquired for cash was not subject to Revlon duties—the duties of a board of directors, once they have decided to sell control of the company, to gain the best available price for the shareholders of that company); cf. In re Lukens Inc. S’holders Litig., 757 A.2d 720, 732 n.25 (Del. Ch. 1999) (suggesting that a merger in which consideration consisted of sixty-two percent cash and thirty-eight percent stock of the acquirer would likely be subject to Revlon duties).

It is not clear why the Occam Court‘s reasoning would not be equally applicable to a stock for stock merger where the target’s stockholders will only own a small percentage of the pro forma combined entity. See Arnold v. Soc’y for Sav. Bancorp., Inc., 650 A.2d 1270 (Del. 1994) for an example of a pure stock for stock transaction in which the court rejected the notion that Revlon duties were triggered even though the acquiror was many times bigger than the target, focusing instead on the lack of a change in control where control of both corporations remains in a large, fluid, changeable and changing market.

Based on the information in the press release announcing the transaction, it appears that Calix/Occam transaction is a 50% cash/$50% stock deal in which the stockholders of Occam are effectively rolling over half of their investment into shares of Calix and will preserve the opportunity to get the same premium as other Calix stockholders if and when Calix is ultimately sold in addition to the 27% premium received in Occam’s acquisition by Calix.