DealLawyers.com Blog

– John Jenkins, Calfee Halter & Griswold

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.