DealLawyers.com Blog

Here is news from Tom Bayliss of Abrams & Bayliss:

On May 13th, the Delaware Court of Chancery issued the attached opinion in Maric Capital Master Fund Ltd. v. PLATO Learning, Inc., C.A. No. 5402-VCS. In the eight-page opinion, Vice Chancellor Leo Strine found that the proxy statement issued in connection with the transaction (a) contained a materially misleading description of how the target’s financial advisor derived the discount rate employed in the discounted cash flow analysis supporting its fairness opinion, (b) omitted material information because it disclosed only select portions of management’s financial projections and (c) created a materially misleading impression about discussions between the acquirer and management regarding post-closing employment arrangements.

The opinion provides helpful guidance regarding the frequently litigated subject of investment banker work product descriptions in proxy statements, reaffirms the Court’s views on the importance of disclosing management projections and highlights disclosure issues lurking in pre-signing discussions between potential acquirers and management regarding post-closing employment.

The Facts

Plaintiff Maric Capital Master Fund, Ltd. (“Maric”) sought a preliminary injunction blocking a proposed merger in which Thoma Bravo, LLC (“Thoma Bravo”) would acquire PLATO Learning, Inc. (“PLATO”) for $5.60 per share in cash. Maric alleged that the directors of PLATO had failed to comply with their obligations under Revlon v. McAndrews & Forbes Holdings, Inc. and that the proxy statement issued by PLATO in anticipation of the stockholder vote contained materially misleading omissions. The Court rejected the Revlon arguments in a yet-to-be transcribed bench ruling. In the written opinion issued only hours later, the Court found the proxy statement materially misleading in three respects.

The Proxy Statement’s Description of Craig-Hallum’s Selection of a Discount Rate

The Court found that the proxy statement contained a materially misleading description of how PLATO’s investment banker, Craig-Hallum Capital Group (“Craig-Hallum”), derived the discount rate used in the discounted cash flow analysis supporting its fairness opinion. The proxy statement explained that Craig-Hallum selected discount rates “based upon an analysis of PLATO’s weighted average cost of capital” and disclosed that Craig-Hallum used a discount rate range of 23% to 27%.

However, the proxy statement did not disclose the fact that Craig-Hallum’s actual analysis (based on comparable companies and a “loose variation” of the capital asset pricing model (“CAPM”)) had resulted in rates of 22.5% and 22.6%. The defendants proffered testimony from Craig-Hallum contending that the higher range was appropriate because PLATO was a micro-cap company with illiquid stock and because the “most comparable” of PLATO’s peers had a discount rate of 25%. The Court rejected this explanation because (a) there was no evidence that it was given to PLATO’s Special Committee and (b) “the only tangible evidence of actual analysis by Craig-Hallum” (emphasis in the original) was the work product generating the 22.5% and 22.6% figures.

The fact that the 23% to 27% range employed by Craig-Hallum was “comprised of eyebrow-raising premiums” that were “heaped on top of the core CAPM analysis” (including a technology industry risk premium of 1.4%, a small cap premium of 9.5% and a liquidity discount) heightened the Court’s skepticism.

Noting that the higher discount rate range resulted in a lower DCF value for PLATO and made the merger consideration appear more attractive, the Court concluded that the merger should be enjoined “unless the proxy statement is supplemented by a corrective disclosure indicating the value that would be obtained by using the discount rates Craig-Hallum actually calculated.”

The Proxy Statement’s Disclosure of Management’s Projections

The Court found that the proxy statement omitted material information because it disclosed only a portion of the management projections provided to Craig-Hallum. Specifically, the proxy statement disclosed management’s estimates of revenue, gross profit, operating income, net income and EBITDA through October 31, 2014, but omitted management’s estimates of free cash flow.

The Court found this omission “odd,” and confirmed the view articulated in In re Netsmart that “management’s best estimate of the future cash flow of a corporation that is proposed to be sold in a cash merger is clearly material information.” The Court concluded that the proxy statement omitted material information “by, for reasons not adequately explained, selectively removing the free cash flow estimates from the projections provided to PLATO’s stockholders.” The Court held that the merger should be enjoined “[u]ntil this information is disclosed.”

The Proxy Statement’s Disclosure of Discussions Between Thoma Bravo and Management Regarding Employment

The Court found that the proxy statement’s description of management contact with Thoma Bravo was materially misleading. The challenged disclosure explained that ‘”[i]n reaching their decision to approve the merger and the merger agreement,’ PLATO’s special committee and board considered ‘the fact that Thoma Bravo did not negotiate terms of employment, including any compensation arrangements or equity participation in the surviving corporation, with [PLATO’s] management for the period after the merger closes.”‘

The Court determined that the statement suggested that the “decision whether to sell PLATO to Thoma Bravo was unaffected by any understandings between Thoma Bravo and the company’s management about future economic arrangements.” But the factual record developed during discovery established that PLATO’s CEO had “extended discussions with Thoma Bravo.” The CEO was “led to believe” that the typical equity incentive package could be expected, and he was “assured” that Thoma Bravo “typically liked to keep existing management after an acquisition.”

The Court acknowledged that these discussions may not have been “negotiations” over a formal employment agreement, but it found that the proxy statement created the “materially misleading impression that management was given no expectations regarding the treatment they could receive from Thoma Bravo.” The Court ordered that the proxy statement be corrected to “clarify the extent of the actual discussions between [the CEO] and Thoma Bravo.”

Take-Aways

1. The Court’s skepticism about Craig-Hallum’s discount rate serves as a warning to financial advisors and their lawyers, as well as to lawyers representing boards relying on financial analysis. As a substantive matter, the Court’s discussion about “eyebrow raising premiums” layered on top of a discount rate calculation based on CAPM indicates that the Court may not be receptive to a tool often used by financial advisors to rationalize discount rates that appear too low when compared to those of comparable companies.

The Court’s insistence that “actual analysis” support the chosen range of discount rates employed in a discounted cash flow valuation suggests that financial advisors will have an increasingly difficult time in Delaware relying on “judgment” to justify departures from ranges derived using accepted valuation methodologies.

2. The Court’s analysis helps illuminate the difference between disclosure claims that can be dismissed as mere “quibbles” with a financial advisors’ analysis and disclosure claims that can result in deal-stopping injunctions and large fee awards to plaintiffs’ lawyers.

Here, the disputed facts involved a financial advisor that chose a discount rate outside the range implied by its own valuation analysis. If Craig-Hallum had chosen a discount rate at the high end of a derived range, the Court might well have overruled the challenge.

3. The Court’s decision to require the disclosure of the valuations implied by Craig-Hallum derived discount rates (rather than its selected range of discount rates) demonstrates how a disclosure deficiency may result in what amounts to a “penalty” disclosure.

Here, the target will likely end up disclosing a per share value implied by a discounted cash flow analysis which neither its board nor its financial advisor believe is supportable. In the context of a contested solicitation where the result is expected to be close, this type of penalty disclosure could easily provide substantive ammunition to an insurgent soliciting against the transaction.

4. The opinion’s emphasis on the importance of disclosing management projections is yet another data point in a range of opinions that many practitioners find difficult to reconcile. See, e.g., In re 3Com S’holders Litig., C.A. No. 5067-CC, 2009 WL 5173804, at *2 (Del. Ch. Dec. 18, 2009).

Although the Maric Capital opinion could be read to apply only to partial disclosures, the Court’s language and reasoning is broadly applicable. Especially when considered together with Vice Chancellor Laster’s musings in In re Zenith National, C.A. No. 5296-VCL (Del. Ch. Apr. 22, 2010) (Transcript), the Maric Capital opinion suggests that target companies subject themselves to a significant risk when they fail to disclose management projections provided to financial advisors. The opinion also helps answer an often-posed question regarding how much of management’s forecasts should be disclosed – if the management projections include free cash flow estimates, they should be disclosed absent some articulated justification.

5. The opinion’s holding regarding Thoma Bravo’s discussions with management underscores the danger of failing to describe (or giving a misleading impression of) preliminary discussions between a potential acquirer and management regarding post-closing employment and compensation, even when those discussions stop short of formal negotiations over contractual matters. The opinion indicates that Delaware courts remain particularly sensitive to the potential conflicts raised by pre-signing employment related discussions with high-level management.

Here is news culled from this Kaye Scholer memo:

Last week, the Federal Trade Commission filed a lawsuit seeking to unwind Dunn & Bradstreet Corporation’s $29 million acquisition from Scholastic Corporation of a competing database for marketing to kindergarten through twelfth-grade teachers, administrators, schools, and school districts. This is the fourth challenge to a consummated transaction below the Hart-Scott-Rodino filing threshold in the last six months, indicating that federal antitrust agencies are looking carefully at transactions of all sizes, and almost no transaction is too small to escape scrutiny.

In this memo, Milbank Tweed’s Bob Reder discusses a recent court decision – In Re Sunbelt Beverage Corp. – in which the Delaware Chancery Court applied the entire fairness standard in reviewing a freeze-out merger involving Sunbelt Beverage Corporation. In siding with a minority shareholder, the court determined that the merger’s sole purpose was to exclude a minority shareholder from participating in an attractive post-merger transaction.

Here are some thoughts from the memo:

Typically, care is taken in corporate transactions in which minority shareholders are treated differently from the majority to incorporate procedural devices aimed to ensure the transaction will survive an entire fairness analysis. There is no per se rule that prohibits the majority from using its superior voting power to “freeze out” the minority; however, courts will not simply defer to such use of majority power, but rather will closely scrutinize the process employed. If the court perceives that the process is unfair, then it becomes exceedingly difficult for the majority to carry the burden of establishing both fair dealing and fair price. It’s incumbent on dealmakers and their legal counsel to resist the temptation to allow the majority to flex its muscle without taking the necessary procedural steps to shift the burden of proving entire fairness to the minority.

A while back, a member noted how there have been some successful responses to SEC comments regarding cautionary language when it comes to an opinion provider’s contingent fees. For example, below is an excerpt of a response (culled from this full response):

Also in our conversation, you indicated that the Staff believes it would be appropriate to include cautionary disclosure relating to the fact that a significant portion of Credit Suisse’s fee is contingent upon the consummation of the merger. In response, we respectfully disagree with this comment and do not believe that such additional disclosure is necessary or appropriate. Our reasons for not adding the additional disclosure requested by the Staff include:

– A review of the proxy statements for the largest M&A transactions in 2008 indicates that disclosure of cautionary language regarding contingent fees is not customary.

– In response to objections by issuers, the Staff has not insisted on disclosure responsive to similar comments:

– Staff comments and issuer responses in connection with the Sirius/XM Satellite transaction are available here, here and here.

Ultimately resulting in the following comment and response:

“Risk Factors, page 16

We note your statement in response to our prior comment four that neither company believes that the transaction’s contingency fee arrangements raise potential risk factor disclosure issues relating to the independence and quality of their respective financial advisor’s recommendation. Please disclose whether either Board considered the issue at all and, if so, why they concluded that the contingency fee arrangements do not compromise the independence and quality of their respective financial advisor’s recommendation.

In response to the Staff’s comment, the disclosure on pages 35 and 42 has been revised to reflect that each of the SIRIUS Board of Directors and the XM Board of Directors reviewed the material terms of the engagement letters of their respective financial advisors, including the contingent fee structure which was considered to be customary and appropriate for this type of transaction.”

Please note, if requested by the Staff, the Company would consider including similar disclosure on page 8 of the Proxy Statement under the caption “THE MERGER–Reasons for the Merger; Recommendation of Sun’s Board of Directors” to indicate that the Company’s Board reviewed the material terms of the Credit Suisse engagement letter, including the contingent fee structure which it considered to be customary and appropriate for this type of transaction.

– See also Staff comments and issuer responses in connection with the Host Marriott/Starwood transaction, available here and here.

Ultimately, no risk factor type disclosure was required. See this amendment to a Form S-4.

As noted in the Host Marriott/Starwood correspondence with the Staff:

– a contingent fee arrangement between a company and its financial advisor is customary for transactions of this nature;

– the Proxy Statement fully responds to the requirements of Item 1015(b)(4) of Regulation M-A to describe “any material relationship that existed during the past two years or is mutually understood to be contemplated and any compensation received or to be received as a result of the relationship . . ;”

– the requested disclosure reflects a conclusion (i.e., that the contingent nature of the financial advisor’s fee constitutes a conflict of interest) and we believe that it is sufficient to disclose the factual information regarding the amount and structure of the fee from which recipients of the Proxy Statement may reach their own conclusion; and

– the Delaware Court of Chancery has considered contingent fee arrangements and expressed doubt that a large investment bank with “serious reputational interests at stake” would advise its client in such a manner as to maximize its fee. See In re Toys “R” Us, Inc. Shareholder Litig., 877 A.2d 975, 1005 (Del. Ch. 2005) (holding that there was no basis to conclude that the potential fees to be paid to a financial advisor influenced its advice to the Toys “R” Us board of directors).

Based upon the foregoing, the Company does not believe that additional disclosure is necessary or appropriate. If the Staff continues to believe that such disclosure is necessary, we respectfully request the opportunity to discuss with you at your earliest convenience.

Here is news culled from this Davis Polk memo:

Last Friday, the FDIC issued new Q&As that clarify certain aspects of its Statement of Policy on Failed Bank Acquisitions, but leave the contours of the Policy Statement largely intact.

While there are still ambiguities in the Policy Statement, it is fair to say that the FDIC is signaling a practical way forward for private investors to enter the queue for failed institutions. The April Q&As provide clarity about the so-called “one-third test,” requirements for offshore investors, information requirements applicable to non-Policy Statement investors and the application of the Policy Statement to recapitalization transactions. It will remain extremely important for private investors to engage the FDIC staff, as every transaction will inevitably require some degree of judgment and discretion on the part of the FDIC on a variety of supervisory issues, including the Policy Statement.

In this podcast, Bob Kuhns of Dorsey & Whitney explains how to handle mini-tender offers conducted by others, including:

– What is a “mini tender offer”?
– What do parties conducting mini tender offers file with the SEC?
– How can companies become aware that a mini tender is happening with their stock?
– What can companies do to combat mini tenders?

Tune in tomorrow for the webcast – “Smaller Company M&A: The Latest Developments” – to hear Diane Holt Frankle of DLA Piper, Mark Filippell of Western Reserve Partners, John Jenkins of Calfee, Halter & Griswold and Bob Kuhns of Dorsey & Whitney discuss all you need to know about doing private and public deals when smaller companies are either the acquirer or the acquiree.

Last week, Tulane held its annual M&A conference. I didn’t make it out there but here are notes from some folks that did:

– DealBook’s Tulane 2010 Page

– Delaware Corporate & Commercial Litigation Blog

– Reuter’s Tulane M&A Conference Live Blog

Yesterday, the Federal Trade Commission released proposed new federal merger guidelines. The guidelines outline how the FTC and the Department of Justice review horizontal mergers, or mergers between actual or potential competitors, under the federal antitrust laws. The FTC will accept comments until May 20th.

Here is some analysis, courtesy of David Foster and Dan Wellington of Fulbright & Jaworski:

Without radically altering the analytical framework of the old guidelines, the new guidelines offer practical insight into how the enforcement agencies evaluate mergers. For example, in a new section called “Evidence of Adverse Competitive Effects,” the agencies note the importance of documents obtained from the merging parties (particularly documents “created in the normal course” rather than “as advocacy materials in merger review”) and of the views of customers affected by the merger.

In defining product and geographic markets, the guidelines suggest that the agencies will typically ask whether the post-merger firm could impose a price increase of as much as 10% before losing profits to competitors. The new guidelines stress flexibility, saying that merger review is a “fact-specific process” and that the agencies “apply a range of analytical tools.”

The new guidelines also update the agencies’ discussion of market concentration, which they generally measure by use of the Herfindahl-Hirschman Index (HHI). The HHI is the sum of the squares of each firm’s market share, meaning that a market divided equally among four sellers would have an HHI of 2,500 (25²+25²+25²+25²). The guidelines state that the agencies will consider markets “unconcentrated” if, after the merger, they have an HHI below 1,500 (an increase from a threshold of 1,000 in the old guidelines).

The new guidelines do not deem markets “highly concentrated” until they reach an HHI of 2,500 (formerly 1,800). A merger producing an increase of more than 200 points in the HHI and a post-merger HHI exceeding 2,500 will create a “presumption” of anticompetitive effect.

The proposed guidelines also add new sections on “powerful buyers,” whose presence in the market might offset competitive concerns; mergers between competing buyers, which can also harm competition; and partial acquisitions, such as the purchase of minority positions, which can have anticompetitive effects in some circumstances.

We have posted the transcript from the recent webcast: “Seller’s Key Issues in 2010: Still a Tough Seller’s Market.”