On January 28th, the Delaware Supreme Court issued a decision in King v. VeriFone Holdings, Inc., No. 330, 2010. The twenty-four page opinion reverses a Court of Chancery decision dismissing a books and records suit under 8 Del. C. § 220 because the stockholder plaintiff had previously initiated a derivative action in California. The Supreme Court’s opinion is important because it rejects a bright-line rule that would require stockholders seeking books and records to demand them first, before filing corresponding derivative litigation.
Take Aways:
1. In the opinion, Vice Chancellor Strine articulated several policy reasons for imposing a rule requiring the submission of a books and records demand before the initiation of derivative litigation. Writing for the Court en banc, Justice Jacobs acknowledged the legitimacy of these policy concerns but determined that a bright-line rule was inconsistent with the results reached in Disney, McKesson HBOC and CNET — three cases which allowed § 220 inspections despite the plaintiff’s prior initiation of derivative litigation. Ironically, practitioners have generally viewed Disney, McKesson, HBOC and CNET and their tortured histories (including failed attempts to plead demand futility) as examples of what not to do as a plaintiff when pursuing derivative claims against a Delaware corporation.
2. Read broadly, the result in VeriFone suggests that stockholders of Delaware corporations may simultaneously pursue corporate books and records under § 220 and derivative claims against the corporation’s directors and officers. This timing issue is critical, because under prior law (at least as it was understood by the Court of Chancery), derivative plaintiffs had to elect whether to (a) seek books and records and then follow with a detailed, fact laden derivative complaint or (b) file suit quickly without seeking books and records to maximize the chance of winning the race to the courthouse (and capturing lead plaintiff status).
3. Anecdotal evidence suggests that under the prior rule, most derivative plaintiffs chose to forego § 220 inspections, win the race to the courthouse and then fight dismissal on typically weak pleadings drafted without the benefit of access to the corporation’s books and records. VeriFone appears to allow stockholders who win the race to the courthouse to avail themselves of the benefit of § 220 after having captured lead plaintiff status (once they know whether the investment in time and resources is likely to pay off). This may lead to more § 220 inspections and better derivative pleadings in the long run, but it undercuts the incentive to conduct pre-suit § 220 inspections, something the Delaware Supreme Court and the Court of Chancery have long encouraged.
4. The result in VeriFone seems to cut against the result contemplated by Court of Chancery Rule 23.1 and analogous rules in other jurisdictions (including Federal Rule 23.1) which have been interpreted to bar discovery until a derivative plaintiff satisfies its substantial pleading burdens. VeriFone appears to envision a regime in which a stockholder can seek indirectly — through a books and records inspection — precisely the type of information that the stockholder cannot seek directly in the pending derivative action before surviving a motion to dismiss. If VeriFone allows this end run around federal pleading requirements, it could reinvigorate pre-emption arguments that, at least until now, have made little headway in § 220 cases.
5. Future litigants will dispute whether VeriFone should be limited to its facts. The stockholder in VeriFone had brought derivative litigation in the United States District Court for the Northern District of California. The federal court had dismissed the stockholder’s suit without prejudice and suggested that the stockholder “engage in further investigation to assert additional particularized facts” by filing a Section 220 action in Delaware. It is unclear whether the federal court’s instruction played a critical role in the Supreme Court’s decision-making process.
6. Future litigants may also dispute whether some form of dismissal is required before the holding in VeriFone becomes applicable. However, it is not entirely clear why the opinion should be limited in that way. The plaintiff in VeriFone filed an amended derivative complaint in federal court during the pendency of the § 220 proceeding. Thus, the Supreme Court’s decision appears to validate the use of a § 220 proceeding to support a pending derivative action regardless of a prior dismissal order.
7. In the opinion, the Supreme Court emphasizes that filing a derivative suit first and then seeking books and records is “ill-advised” and “may well prove imprudent and cost-ineffective.” However, the powerful incentives that drive the race to the courthouse will likely overwhelm these warnings, particularly if a books and records inspection is available after the commencement of a derivative suit. Because of this dynamic, VeriFone may reduce the number of pre-suit § 220 demands (and increase the number of post-suit § 220 demands) served on Delaware corporations.
8. The result in VeriFone may increase the likelihood that corporate defendants will face two suits filed by the same plaintiff in different jurisdictions – one seeking books and records and another seeking damages and other relief against the corporation’s officers and directors. A representative plaintiff may be better off filing its books and records suit and its derivative suit in different jurisdictions to avoid arguments that the books and records demand constitutes impermissible backdoor discovery prohibited by Court of Chancery Rule 23.1 or the analogous rule in the applicable forum. However, VeriFone could be interpreted to allow this backdoor discovery as matter of right.
9. The result in VeriFone may widen a chink in the armor of corporate defendants that are otherwise protected by the automatic discovery stay in the Private Securities Litigation Reform Act. Derivative actions have always represented a potential vulnerability to these defendants, but the high pleading burdens associated with those derivative actions have typically served as a formidable barrier. VeriFone may presage a new breed of derivative litigation that involves complaints armed with details from post-suit books and records inspections.
10. The Supreme Court emphasizes that “[i]f relief under Section 220 is to be restricted in the manner adjudicated by the Court of Chancery, any such restriction should be imposed by the General Assembly, not decreed by judicial common law decision-making.” It is unclear whether the General Assembly will respond to this invitation.
11. The VeriFone decision may not have any effect on the parties to that action. In a footnote, the Supreme Court acknowledges that the federal district court had dismissed the stockholder plaintiff’s derivative suit with prejudice during the pendency of the appeal. The Supreme Court refused to find that this development mooted the dispute because the Court of Chancery’s decision announced a principle of Delaware law “that could have significant impact in future cases… and should be subject to appellate review before it becomes operational prospectively.”
Tune in tomorrow for the DealLawyers.com webcast – “Recent Developments Regarding Fairness Opinions, Valuation Analyses and Related Topics” – to hear Kevin Miller of Alston & Bird, Steve Kotran of Sullivan & Cromwell, Stuart Rogers of Credit Suisse Securities and Jennifer Muller of Houlihan Lokey discuss the latest developments and trends of fairness opinions and valuation analyses. Please print off these course materials before the program.
This January-February issue of the Deal Lawyers print newsletter was just sent to the printer and includes articles on:
– How to Respond to Shareholder Proposals Seeking Board Declassification
– The ABCs of Board De-Staggering
– Acquiring US Companies with Foreign Subsidiaries: Relevant Issues
– The Window Closing Pill: One Response to Stealth Stock Acquistions
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Following trial in In re John Q. Hammons Hotels Inc. Shareholder Litigation, the Delaware Court of Chancery ruled in favor of defendants, finding that the merger price was fair value, that controlling stockholder John Q. Hammons did not breach his fiduciary duties, and that the third-party acquirers did not aid and abet a (nonexistent) fiduciary duty breach.
In the Court’s summary judgment opinion in this case, the Court applied the entire fairness standard of review to the merger, which involved the third-party purchase of a corporation with a controlling stockholder who received consideration that was different from the minority. Because the transaction was approved by an independent and disinterested special committee, plaintiffs bore the burden at trial of proving the transaction was unfair. In its post-trial opinion, the Court noted that defendants “may actually have been entitled to business judgment rule protection,” but it analyzed the transaction under the entire fairness standard and found the process and the price to be fair.
The Court found that Mr. Hammons did not breach any fiduciary duties, particularly as he took less per-share consideration than the minority stockholders received. Finally, because no fiduciary duties had been breached, the Court rejected the claim against the acquirers for aiding and abetting.
Last week, Industrial and Commercial Bank of China announced that it had entered into an agreement to purchase 80 percent of the outstanding common stock of the U.S. subsidiary bank of The Bank of East Asia, Limited, a privately held Hong Kong-based bank. Bank of East Asia also has an option to sell to ICBC its remaining 20% interest in the U.S. bank for a period of 10 years following the acquisition. Although relatively small in size, this transaction is a most significant precedent. The ICBC deal would mark the first control acquisition by a mainland Chinese bank of a U.S. bank since Congress passed a law in 1991 substantially tightening the regulation of foreign banks operating in the U.S. following the collapse of BCCI. The transaction could be the start of a very significant new dynamic in U.S. bank M&A.
Chinese banks have tried for years to try to persuade U.S. regulators to permit them to acquire a U.S. bank. The primary regulatory obstacle has been that, by law, the Federal Reserve may not approve an acquisition by a foreign bank of a U.S. bank unless the Federal Reserve determines that the foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home country supervisor. To do so, the Federal Reserve must find that the foreign bank is supervised or regulated so that its home country supervisor receives sufficient information on the worldwide operations of the bank, including its relationship to any affiliates, to assess the bank’s overall financial condition and its compliance with law and regulation.
An initial determination by the Federal Reserve that a foreign bank regulator exercises comprehensive consolidated supervision is highly fact dependent and can take years of analysis and deliberation. Here, the analysis is made more challenging by significant factors specific to China, including the unique structure of the Chinese political system, and the extremely rapid pace of change in China’s economy and financial markets. That being said, once the Federal Reserve has determined that a foreign bank regulator meets this standard, the determination becomes much less of an issue in subsequent acquisitions by the same bank or by other banks from that country.
The transaction is subject to regulatory approval, and both the U.S. Committee on Foreign Investment in the U.S. (an interagency committee headed by the Secretary of the Treasury) and the Federal Reserve will certainly give it a close review. However, given the larger political context and the events surrounding the announcement of the deal, it seems likely that the parties have carefully vetted this transaction from all relevant angles.
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.
Last week, the Federal Trade Commission announced the annual adjustment of its HSR thresholds, the ones that dicate which mergers and acquisitions must be reported to the FTC and DOJ. Once the new HSR thresholds go into effect – they will apply to deals closed 30 days after the thresholds are published in the Federal Register – notification will be required if the acquiror holds another person’s assets or voting securities valued in excess of $66.0 million (previously $63.4 million), and
– The transaction involves one party with annual net sales or total assets of $13.2 million or more (previously $12.7 million) and another party with annual net sales or total assets of $131.9 million or more (previously $126.9 million); or
– The acquiring party will hold assets or voting securities of another person valued in excess of $263.8 million (previously $253.7 million).
In their “Tuesday Blog Series,” Horizon Partners – a boutique M&A firm – gives some helpful insight on how a financial advisory firm views certain components of purchase agreements.
2010 recap:
– It was the year of the PE comeback (global deal value was up over 90%)
– Defined by a two-speed recovery, with momentum building in emerging markets versus limited deal activity in developed markets (BRIC M&A deal value was up more than 46%)
2011 outlook:
– Companies are nervous to pull the trigger (Only 41% of companies are planning on making an acquisition over the next 6-12 months vs. 57% in April 2010)
– More focus on organic growth ( 75% of companies are more focused on organic growth vs. 66% six months ago)
– Fewer “do-or-die” transactions – more strategic M&A. Bargain-basement deals declining, valuation multiples improving
– One foot on the accelerator, one foot on the brake: Boardrooms are cautious right now, but paradoxically 50% of companies are ready to execute an acquisition at short notice – up from 36% a year ago.
– All the pieces are in place for a resurgence, but confidence and clarity about direction of economic recovery will be crucial
– Lots of pent-up demand – record levels of cash on corporate balance sheets and in PE coffers
– More hostile bids – an indication of early stages of an M&A recovery
– Hot Industries – The sectors that will be ripe for activity include energy, technology, healthcare, and financial services
Below is a summary of Stikeman Elliott’s analysis of M&A Trends for this year, culled from this full report:
As the global financial storm subsides, Canada’s economy is commanding unaccustomed attention and some new-found respect. A solid regulatory system and strong demand for Canadian resources and commodities have kept the country in the business headlines for all the right reasons. In the M&A sector, there is every indication that the rebound experienced in 2010 will continue in 2011, as market players continue to adjust and adapt. We believe that each of the trends identified below will play a part in shaping the market – whether it’s creative methods of financing, more realistic valuation methods, adjustment to deal terms or regulatory developments in the areas of foreign investment, taxation and securities law.
M&A Trends 11 for ’11
1. Investment Canada: Business as usual for foreign investors in 2011
2. Canadian poison pills gain strength: Just saying no may be getting easier
3. The commodities sector: No end in sight to foreign demand
4. Financing and valuation:Techniques for bridging the gaps
5. Hedge funds, pension funds and other pools of capital
6. Growth of a domestic high-yield debt market: A positive result of low interest rates
7. Going with the (cash) flow in valuations
8. Income tax: Recent developments generally positive for M&A
9. Structuring investments in M&A transactions: Bilateral investment treaties
10. Infrastructure: One of the hottest M&A tickets for 2011
11. Deal terms in Canada and the U.S.: Similarities and differences