Surprising given the environment, a number of law firms are taking advantage of the upcoming NASPP online course “Tackling Equity Compensation Issues Related to Mergers & Acquisitions.” My guess is that the slow deal market gives folks time to train. If you wish to participate and are not a member of the NASPP, shoot me an email and I can help you work with the NASPP to get the member rate and participate.
As reported by The New York Times and other media outlets when the deal was first announced, the merger agreement for Pfizer’s $68 billion acquisition of Wyeth contains an eye-opening $4.5 billion reverse break-up fee. That’s over 6.6% of the deal’s reported value, and would certainly push the limits of Delaware’s tolerance for deal protections if it was the seller paying that kind of fee.
The deal calls for Wyeth shareholders to receive a combination of cash and Pfizer stock, and Pfizer reportedly intends to borrow $22.5 billion necessary to finance the cash component of the consideration from its lenders. That’s apparently where the reverse break-up fee comes in.
Pfizer’s press release announcing the deal notes that it contains a financing condition that would allow the deal to be terminated if Pfizer’s lenders declined to provide financing “due to a material adverse change with respect to Pfizer or Pfizer failing to maintain credit ratings of A2/A long-term stable/stable and A1/P1 short term affirmed.” In essence, the reverse break-up fee is intended to compensate Wyeth if the deal falls through because the financing condition is not satisfied. (It’s not quite that simple, as Prof. Steven Davidoff points out in his analysis of the Pfizer/Wyeth deal structure.)
Breakup fees payable by a seller in the event that a deal is terminated have been a common feature of merger agreements for decades and, like other deal protections, have received a lot of attention from the Delaware courts. (See this article from the “Harvard Corporate Governance Blog” for a discussion of some of the more recent cases addressing deal protections). However, reverse break-up fees payable by a buyer to walk away from a transaction have not received much attention from the courts.
It is not entirely clear how Delaware courts are likely to view reverse break-up fee arrangements, but the circumstances under which buyers’ generally agree to pay them are different from those in which sellers’ generally agree to pay traditional break-up fees. Those differences suggest that the heightened scrutiny that Delaware courts apply to seller break-up fees under the Unocal doctrine should not be applied to most reverse break-up fees.
A seller’s obligation to pay a break-up fee is usually associated with the termination of a deal in connection with a competing proposal. For example, sellers are frequently required to pay these fees if they terminate a deal to accept a “superior proposal,” if they breach a no-shop covenant, or if their shareholders turn down a deal after a competing bid has been made public. In contrast, reverse break-up fees are, as in the Pfizer/Wyeth situation, usually tied to an express or implicit “financing out” for the buyer.
The Delaware courts apply Unocal to seller break-up fees because, like other deal protection measures, break-up fees may deter competing bids and allow the board to protect a favored transaction. This raises the risk that the directors’ decision to agree to these protections might be motivated by a desire to entrench themselves, and that is exactly the kind of concern that prompted Delaware to adopt the Unocal standard in the first place.
Those concerns usually aren’t present in the context of a typical reverse break-up fee arrangement. Reverse break-up fees have been around for a long time, but became increasingly prevalent during the middle part of this decade, as private equity firms sought to provide some assurance of their bona fides to potential sellers, while at the same limiting their exposure to those sellers. In fact, private equity reverse break-up fees have famously been described by Prof. Davidoff as effectively giving private equity buyers options on the companies that agreed to them. It is unusual to see a reverse break-up fee in a deal involving a strategic buyer – particularly one as bankable as Pfizer – but then again, these are interesting times.
In any event, it is hard to identify an entrenchment motive in a seller’s desire to seek compensation if a buyer can’t come up with the funds it needs to close a deal. More to the point, it is hard to find an entrenchment motive in a buyer’s efforts to protect itself from potentially significant damage claims (or actions seeking specific performance) in the event that its financing falls through.
Then again, never say never. In a 2006 case called Energy Partners v. Stone Energy, CA No. 2402-N (Del. Ch. Oct. 11, 2006), the Delaware chancery court suggested that a buyer’s board’s fiduciary duties sometimes may be implicated when the buyer agrees to deal protections that limit its ability to consider and respond to competing proposals. That is particularly true when the buyer must seek approval for a transaction from its own shareholders.
Although the court did not address the issue of reverse break-up fees, some of the language in Energy Partners could be read to suggest that – given the right alignment of planets – a large enough reverse breakup fee coupled with other deal protections that might deter competing bids for the buyer might prompt a court to apply heightened scrutiny to the buyer’s decision to enter into those arrangements. This article from Potter Anderson provides a detailed discussion of the issues raised by the Energy Partners decision.
The good news is that private equity (“PE”) investments in financial institutions are occurring at an unprecedented pace, and there is a backlog of deals in active discussion with the FRB and the OTS. The better news is that with each new deal, the rules of the road are being clarified and the universe of potential structures is even being expanded as regulators and PE firms get comfortable with each other.
As these transactions are being considered, each one seems to have a slightly different structure and investor make-up, which in turn raises a variety of new issues for regulators and investors that the PE firms attempt to resolve through deal structures, terms and conditions that address the economic and business needs of the parties while still satisfying regulatory concerns. Most recently, the OTS approved the MaitlinPatterson Global Advisors LLC’s application of ten (10) limited partnerships to acquire control of Flagstar Bancorp., Inc. (OTS Order 2009-06, Jan. 29, 2009), which reportedly facilitated the Treasury’s approval of the bank’s TARP assistance application.
Issues that are likely to be further clarified in the future include:
– Acceptable structures and terms for PE consortiums purchasing failed banks from the FDIC (e.g, loss sharing, indemnification, shareholder/LLC agreements and financial terms).
– The practical options provided by “shelf” and “inflatable” charters.
– The role of PE firms in recapitalizing and qualifying banks that are applying for the CPP under TARP.
– The impact of the CPP and the priority of the Treasury when CPP banks seek to recapitalize, merge or be acquired.
– The range of provisions in shareholder and LLC agreements that are consistent with passivity commitments provided by investors.
– The range of relationships between the investing parties that are consistent with commitments regarding not acting in concert.
– The number and nature of director representation that investors may have under a variety of situations, and the independence of the bank’s board of directors.
– The role of capital commitments and source of strength agreements, particularly where the bank participates in the CPP.
– Director interlock, cross guarantee, stock aggregation tracking and affiliate transaction issues.
– How “silo” transactions will need to be structured from an economic and legal perspective.
We continue to be confident that the PE and regulatory worlds have enough good reasons to compromise fundamental principles in order to meet each other half way, and that in the current environment, transactions will continue to occur.
A few weeks ago, Pat McGurn, Special Counsel of RiskMetrics’ ISS Division, participated in a TheCorporateCounsel.net webcast: “Forecast for 2009 Proxy Season: Wild and Woolly.” The excerpt below was culled from the webcast transcript and it deals with mergers & acquisitions (Pat also discussed a number of other “hot” proxy season issues):
Moving on to number seven and leaving the compensation realm is M&A. I think we are going to see probably less so in the first half of the year but more as the year goes on some reignition of fears about M&A activities, especially with many company stocks at historically low price levels. This should bring into sharp focus the shareholder resolutions and other activism on this particular topic that occurs at annual meetings.
This year, I think the runaway hit on the M&A front – as far as shareholder proposals go – is going to be the resolution looking to restore shareholder rights to call special meetings. I think we’re going to see a bumper crop of those proposals. Notably the support for those actually dropped in 2008 as the numbers also rose last year. But we could see given market concerns and accountability concerns more support for those resolutions pushing them back above the 50% on average support level that they got two years ago.
I think one reason for the increase in special meeting proposals is actually a potential decrease in proposals related to the repeal of classified board structures. I think support for the resolutions on the ballot in 2008 actually increased, but the fact of the matter remains that the activists are actually running out of targets in the S&P 500 or large cap universe today, where use of classified board structures is definitely minority practice at this point in time.
Notably, 2008 actually marked the time when we saw the change-over for the entire corporate universe. If you look at the S&P 1500 universe only 50% now have classified board structures in place, which is down nearly 20 percentage points from a number of years ago. So clearly we’re seeing an exodus away from that structure.
One interesting new proposal this year calls for the companies to remember Bismarck and that’s Bismarck, North Dakota. I didn’t check weather.com for the temperature there today but some activist institutions would like to send corporate counsel and other executives there if they want to do their corporate litigation.
As you may be aware, North Dakota adopted a while back one of the most shareholder-friendly statutes in the United States, if not the world, related to corporate governance practices. These resolutions seek to urge boards of directors to reincorporate in that and to make themselves subject to this shareholder-friendly legislation. So an interesting one to watch.
We also expect to see a significant number of proposals asking boards to eliminate their super majority vote requirements as the perennial that does quite well.
One resolution not likely to show up much at all this year are calls for shareholder votes on poison pills. The number of resolutions on this topic has dwindled in recent years as the usage of rights plans has dropped.
The stage at which this issue plays out has really shifted to the board of directors. Last year we saw in a significant number of cases where boards had very large “no” votes that the unilateral non-shareholder approved adoption of a plan by a board of directors was quite often a catalyst for those majority or near majority “no” votes coming in again for the directors.
Given the fact that we’ve seen in recent weeks really a run on pill adoptions especially by small cap and middle market firms, we’re expecting to see some very strong “no” votes show up at annual meetings for those firms this year, although many of them still don’t have majority voting rules in place.
Another ancillary issue here that is picking up some momentum is the notion of revising the advance notice requirement. Some of the changes being made right now are simply housekeeping changes that are being put into place in order to address some concerns raised by some litigation in Delaware last year. But there are a number of boards that have been advised and have gone ahead and adopted even stronger advance notice language that really seeks to enhance disclosure by investors of “synthetic voting rights” and derivative holdings.
This was a big issue in a couple of proxy fights over the last couple of years. But I will issue a note of caution here that some of the language that’s being adopted by some firms seems to be very restrictive and ultimately could serve as a take over defense in and of itself. So boards should probably be wary of adopting advice without viewing it critically, otherwise they may find themselves subject to a no vote campaign.
The health care sector is one of the few areas of the deal economy where M&A activity remains fairly robust, particularly among the multi-national pharmaceutical companies known collectively as “Big Pharma.” For example, Johnson & Johnson announced a $1.1 billion deal last month to acquire Mentor Corporation, and the company recently completed a $358 million acquisition of Omrix BioPharmaceuticals. Earlier this month, GlaxoSmithKline completed its own $57 million purchase of GeneLabs Technologies, and Abbott Laboratories just this week announced a $2.8 billion deal for Advanced Medical Optics.
One of the things that these deals and other recent industry transactions have in common is that they have all been structured as cash tender offers. In a sense, that comes as no surprise – after all, Big Pharma companies have lots of cash, and are operating in an environment where acquisitions are a strategic imperative. That’s a scenario where you can expect to see a lot of competition among buyers, and one where the timing advantages associated with a tender offer would be pretty compelling. On the other hand, over the past decade, tender offers have been less popular in negotiated deals than you might expect, so their use in so many recent deals is something that’s worth noting.
As I alluded to earlier, the big advantage that a deal structured as a “two-step” transaction (an upfront tender offer followed by a back-end merger) enjoys over a traditional “one-step” statutory merger is timing. Since a tender offer only has to remain open for 20 business days, a two-step transaction allows companies an opportunity to close their deals in as little as 30 days from the date the tender is launched. In contrast, one-step transactions involving public company targets may take three months or more to complete.
The reason for this timing advantage is that while a one-step merger requires companies to file preliminary proxy materials with the SEC for review before mailing to shareholders, tender offers can be launched immediately. Companies still face SEC review of their tender offer filings, but that review happens while the offer is being made, and any comments received from the staff can frequently be addressed without the need to extend the offer.
Despite the advantages of a tender offer, it has not been an especially popular deal structure for negotiated transactions in recent years. Legal uncertainties associated with this structure that were only fairly recently addressed by the SEC are probably the biggest reason for this, but private equity’s dominance of the M&A market prior to the credit crunch was also a contributing factor. The legal uncertainties associated with two-step transactions arose from some case law interpretations of Exchange Act Rule 14d-10.
This so-called “best price rule” requires a bidder to pay to any security holder the highest consideration paid to any other security holder in a tender offer. Shareholder plaintiffs contended that severance, retention and other compensatory payments to target executives actually were part of the price those persons received for tendering their shares, and that the best price rule obligated buyers to pay the same compensation to all other shareholders. That meant that if any such payments were made in connection with a tender offer, shareholders would be entitled to a proportionate share of them. This argument received a sympathetic hearing from some courts, and raised the potential that buyers might face staggering damages due solely to the decision to structure a deal as a tender offer. See, e.g., Katt v. Titan Acquisitions, Ltd., 153 F. Supp. 2d 632 (Mid. Tenn. 2000). Given those risks, buyers tended to shy away from this structure.
Private equity firms also did not often structure their deals as tender offers, but not just because of concerns about the way courts might apply the best price rule. The banks that committed to finance private equity deals frequently wanted time to market the debt before funding. As a practical matter, that meant that private equity firms and their lenders weren’t anxious to sign up for a deal that they would be committed to close on before the debt could be placed.
The SEC took steps in late 2006 to address the legal uncertainties associated with the best price rule. Amendments to the rule excluded compensatory payments from its reach and established a safe harbor mechanism by which companies could ensure that their arrangements fit within the exemption. More recently, private equity buyers have headed to the sidelines as debt financing has dried up almost completely. In contrast, financing is not an issue for most Big Pharma companies, which have piles of cash on their balance sheets. With less uncertainty on the legal front, the potential to close weeks or even months more quickly by structuring a deal as a tender offer makes that option very attractive to a cash rich strategic buyer.
That’s especially true when those buyers know that they are likely to face stiff competition from other industry players on almost every deal. In that kind of environment, it’s no surprise that tender offers appear to be making a big comeback, and it’s likely that we’ll continue to see plenty more of these deals over the next 12 months.