May 19, 2011

Delaware Rules Again on Disclosure of Competing Projections

Here’s news – and analysis – from Tom Bayliss of Abrams & Bayliss:

Recently, the Delaware Court of Chancery issued a decision in In re Orchid Cellmark Inc. Shareholder Litigation. The 37-page letter opinion authored by Vice Chancellor John Noble articulates the basis for an order denying an application to enjoin Laboratory Corporation of America Holdings, Inc.’s proposed $85.4 million acquisition of Orchid Cellmark Inc. by first step tender offer and second step merger. The Orchid Cellmark decision provides helpful guidance on the impact of disagreements among board members about the advisability of a transaction, the materiality of projections prepared by management but revised downward by a financial advisor, the disclosure of investment banker work product regarding alternatives that the company declines to pursue and merger agreement provisions that prevent a target from exempting other bidders from its poison pill.

Notable Facts

Four notable facts colored the parties’ dispute over the LabCorp transaction. First, the process leading to the transaction involved dissention among Orchid’s directors. The Company’s CEO and another director voted against continued negotiations with LabCorp at a January 21, 2011 board meeting (they were out-voted by the Company’s four other directors). The Company’s CEO also voted against a binding agreement to provide LabCorp a thirty-day exclusivity period on February 3, 2011. When the board finally approved the LabCorp transaction on April 5, 2011, the CEO abstained from the vote. The Company’s public filings later confirmed that the CEO did not intend to tender his shares in the deal.

Second, the Company’s public filings disclosed that Oppenheimer & Co., Orchid’s financial advisor, had advised the board that “no third party would likely propose a bid for the [C]ompany that would yield a result for the stockholders that would be higher than LabCorp’s … $2.80 per share indication of interest.” But a consortium of private equity firms had verbally expressed interest in purchasing Orchid’s U.K. operations for amounts that implied a value of between $2.74 and $3.04 per share for the Company. Oppenheimer had reduced this range to “approximately $2.93” per share and concluded that the figure was “comparable” to LabCorp’s $2.80 offer, but it had emphasized that the expression of interest remained “preliminary and entaile[d] significant uncertainties.”

Third, Oppenheimer did not adopt, and the Company’s public filings did not disclose, the financial projections prepared by Orchid’s CEO and CFO. Instead, Oppenheimer treated these projections as an “upside case,” contrasted them with lower “base case” and “downside case” projections and ultimately used the “base case” projections when rendering its fairness opinion.

Fourth, Orchid maintained a poison pill, and the merger agreement governing the transaction provided that the Company would exempt only LabCorp from its operation. Section 5.2(a)(v) of the merger agreement expressly prohibited Orchid from exempting other bidders from the pill without first terminating the merger agreement and paying LabCorp a termination fee.

The Rulings

The Court found that the plaintiffs failed to demonstrate a reasonable likelihood of success on their claim that the directors had violated their Revlon duties by failing to consider the CEO’s dissenting views. Vice Chancellor Noble held that the “[b]oard simply disagreed with his optimism toward Orchid’s remaining as a stand-alone company.” The Court determined that the Company’s public filings adequately disclosed dissention at the board level by noting the CEO’s opposition to the transaction and his decision to abstain from the vote to approve the deal. The Court concluded that the split board vote over continuing negotiations with LabCorp was not material and its disclosure would not have altered “the total mix of information available to shareholders.”

The Court found that the plaintiffs failed to demonstrate a reasonable likelihood of success on their claim that the directors had violated their Revlon duties by failing to inform themselves or pursue the private equity firms’ interest in a transaction involving Orchid’s U.K. operations. The Court credited evidence indicating that the board deliberated over the likelihood that the expression of interest would materialize into a superior transaction and discussed the risks associated with pursuing an alternative transaction where no offer had yet been made. The Court ultimately concluded that, while it was possible to “hypothesize a complex, multi-part transaction involving the sale of Orchid’s U.K. business to a private equity firm,” there was “no reason to second guess this [b]oard’s decision.”

The Court rejected the contention that the Company’s public disclosures regarding the potential sale of its U.K. operations were materially misleading. Because of the execution and consummation risk associated with the expression of interest, Oppenheimer’s conclusion that the private equity firms’ proposal regarding the U.K. operations implied a value of $2.93 per share was “not necessarily incompatible” with its publicly disclosed advice that “no third party would likely propose a bid for the Company that would yield a result for the stockholders that would be higher than LabCorp.’s current $2.80 indication of interest.” Moreover, the Court determined that “disclosing the $2.93 per share price, without an accompanying and perhaps confusing modification for the potential negative value in the U.S. or the transaction costs associated with splitting up the Company would have been misleading.”

The Court found that the plaintiffs lacked a reasonable likelihood of success on their claim that the board violated its Revlon duties by “massaging” the projections provided by the CEO and CFO so it could sign-off on the transaction. The Court found no basis to question the motivation of the independent directors or to doubt the independence and credentials of Oppenheimer. By contrast, the CEO (a) held a large number of underwater options and (b) had prepared the projections in response to LabCorp’s acquisition offer. Vice Chancellor Noble emphasized that “[i]n evaluating the fairness and advisability of th[e] tender offer, the Special Committee and its financial advisor [were] not precluded from considering various sets of financial projections before determining that one set reflect[ed] the best estimate of future performance.” The board’s determination that the “‘base case’ most accurately captured Orchid’s future performance” was not “an unreasonable conclusion.”

The Court rejected the contention that the projections prepared by the CEO and CFO should have been disclosed (alongside the base case projections prepared by Oppenheimer), despite the plaintiffs’ characterization of the CEO as “the most knowledgeable person concerning the Company’s operations” and his strong belief that the “management projections were more accurate and reliable than the ‘base case’ developed by Oppenheimer.” The Court noted that the ultimate responsibility for managing the affairs of the Company rested with the board, which had deemed the base case projections more reliable than the projections advocated by the CEO.

The Court found that the plaintiffs failed to demonstrate a reasonable likelihood of success on their claim that Section 5.2(a)(v) of the merger agreement was an unreasonable defensive measure. Although it prevented Orchid from exempting any competing bidder from its poison pill, the board retained its right to terminate the merger agreement (and the limitation on its ability to exempt other suitors from the pill) upon a determination that a competing bid constituted a superior proposal. The applicable termination fee made this option costly, but no more costly than terminating the merger agreement for any other reason.

Take-Aways and Further Thoughts

1. The opinion is a helpful reminder that Revlon does not require consensus at the board level (or even the support of the corporation’s CEO).

2. The opinion provides critical guidance on a difficult disclosure question that arises frequently: if a company and its advisors develop multiple sets of projections and determine to disclose at least one set, must the others be disclosed? The decision in Orchid Cellmark suggests that only the board-endorsed projections relied upon by the financial advisor need to be disclosed. This apparently remains true even when the company’s principal officers provide more optimistic projections and continue to believe that their projections are more reliable than the projections endorsed by the board.

3. Interestingly, the opinion does not appear to accord the CEO’s views on projections disproportionate weight. Presumably the board appointed the CEO after determining that he was the individual best suited to run the Company. It is unclear how the CEO could lose the board’s confidence with respect to forecasting but nevertheless retain the board’s confidence as an operator. The opinion also highlights a potential question: what constitutes so-called “management projections” under Delaware law: (a) projections prepared by officers of the corporation, or (b) projections endorsed by the directors charged with a duty to “manage” the corporation under Section 141(a) of the DGCL?

4. In a footnote, the Court emphasizes that the CEO’s underwater options and the preparation of the projections in response to the LabCorp offer justified “a deviation from the general principle, set forth in such cases as Maric Capital Master Fund, Ltd. … that management’s estimate of cash flow for purposes of assessing a cash merger is clearly material information.” Since target management frequently prepares its projections after the commencement of a sales process, the importance of the CEO’s underwater options in the Court’s calculus may become the focus of future debate. Regardless, Maric is distinguishable when there is “obvious tension” between the CEO and the board and the board makes a “collective decision to move forward” using projections prepared by others.

5. The Court explains that it was “not for this Court to question that decision or to determine which set of projections better captures the Company’s financial condition where the [b]oard’s decision appears to be reasonable.” Of course, one could argue that the disagreement militated in favor of disclosing both sets of projections so the stockholders could assess those provided by management and compare them to the projections endorsed by the board. For similar reasons, one could argue that the existence of the disagreement over the projections was a material fact warranting disclosure and explanation.

6. The opinion acknowledges that the ruling on the materiality of the expression of interest in the Company’s U.K. operations and Oppenheimer’s analysis suggesting that the transaction implied a value of $2.93 per share was a “close call.” The Court appears to have been persuaded in part by the suggestion that it might be “misleading to disclose the $2.93 per share price without … accompanying and perhaps confusing” details. But it is unclear why the directors could not be charged with an obligation to disclose the analysis to their stockholders in the same plain English used describe complicated financial analyses routinely conducted by their financial advisors.

7. The Court’s endorsement of merger agreement provisions limiting the ability of a target to exempt competing bidders from its poison pill is a helpful guidepost. The Court notes that “a sophisticated and serious bidder would understand that the [b]oard would likely eventually be required by Delaware law to pull the pill in response to a [s]uperior [o]ffer.” The Court stops short of addressing the potential impact of such a pill on the post-announcement aggregation of significant positions by arbitrageurs potentially interested in exercising bargaining leverage based on their accumulated stakes.

8. The opinion is the second instance in which the Court of Chancery has assessed the preclusive effect of a termination fee based on its percentage of the target’s aggregate equity value, despite the target’s significant cash reserves. Commentators have noted that enterprise value may be a better metric for assessing the impact of a termination fee on an acquirer because it often provides a better estimate of the aggregate consideration required from the acquirer and its financing sources to complete the transaction. In Orchid’s case, the $2.5 million termination fee represented less than 3% of the Company’s equity value but 4.6% of the Company’s enterprise value because of its $19.8 million in cash on hand.