Last night, the Delaware Supreme Court delivered the much anticipated decision in Lyondell Chemical Company v. Ryan (No. 401, 2008). The decision reverses last year’s widely-followed opinion of the Court of Chancery declining to grant summary judgment in favor of the defendant directors of Lyondell Chemical Company (“Lyondell”) on Revlon claims.
Having taken the rare action of granting defendants’ interlocutory appeal from a decision denying summary judgment, the Delaware Supreme Court took the even rarer action of not only reversing the Court of Chancery but also entering summary judgment in favor of the defendant directors. In so doing, the Supreme Court with surprising terseness decided what apparently is a novel issue of Delaware law: precisely when Revlon duties arise.
As set forth by the Supreme Court, Revlon duties arise not when a company is put in play (such as in the case of Ryan when a Schedule 13D puts a company in play), but “when a company embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control.” Here, the Supreme Court held that Revlon duties did not arise until the target directors actually began negotiating the sale of Lyondell. Rather, the decision to “wait and see” was subject to the deferential business judgment rule.
The Supreme Court moreover directed the focus of any relevant inquiry on the affirmative actions of the directions (i.e., what the directors did do), as opposed to what they did not do. Ultimately, the Supreme Court admonished: “[t]he trial court approached the record from the wrong perspective. Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.”
The particular factual allegations underlying this decision bear emphasis and provide transparency into where the Supreme Court was coming from: the consideration paid to Lyondell stockholders represented a 45% premium over the closing stock price of Lyondell immediately before the market learned of the would-be acquirer’s interest in Lyondell from the above referenced Schedule 13D; the transaction was approved by an independent and disinterested board; and the merger was additionally approved by 99.33% of the shares voting in favor of the transaction (equal to 65.80% of the total outstanding shares).
The merger transaction thus represented a substantial premium, lacked any of the hallmark conflicted director/shareholder suitors that typically predominate these types of challenged transactions, and garnered the resounding endorsement of the Lyondell shareholders.
At the end of the day, the Court’s outcome is not altogether surprising given this confluence of unusual facts and the decision to grant interlocutory appeal in the first place. The short 20-page opinion is a “must read” for M&A practitioners and surely will serve as fodder for much discussion and debate in the months to come.
A member recently asked in the DealLawyers.com “Q&A Forum” about the rationale for including “flip-in” and “flip-over” provisions in shareholder rights plans, or “poison pills.” When a company adopts a rights plan, it typically issues of a right to purchase a fraction of a share of preferred stock as a dividend to all of the issuing company’s shareholders. The exercise price of the rights is usually based on an assessment of the price that it would be reasonable to expect the stock to achieve over the life of the rights plan. Frequently, the board receives input from a financial advisor in setting the exercise price of the rights at the time they are issued.
These rights do not become exercisable until a raider acquires beneficial ownership of a specified percentage of the target’s outstanding shares. (That percentage is usually between 10% and 20% of the outstanding shares, but in the case of NOL pills, it is typically set at 4.9 %.). When a raider crosses that threshold, the rights detach and become exercisable — except for those rights that are held by the raider, which when you get right down to it is what makes pills work in the first place.
Rights plans typically include both “flip-in” and “flip-over” features. The plan’s “flip-in” feature comes into play when a raider triggers the rights plan by acquiring the percentage of the target’s common stock specified in the plan. When this happens, each right then outstanding (other than those held by the buyer) “flips-in” and gives each holder the right to purchase shares of the target’s common stock with a market value equal to twice the exercise price of the right.
What a flip-in provision does is deter the buyer from crossing the ownership threshold that will trigger the rights plan by confronting it with the prospect of substantial dilution. Since every holder except the buyer will be able to purchase new shares at a 50% discount to current market, the buyer’s ownership interest will be diluted if the flip-in provision of the rights plan kicks in. The actual amount of that dilution will depend on the exercise price of the rights, but it is almost invariably going to be quite substantial – substantial enough to make triggering the rights economically unviable.
A “flip-over” feature is intended to protect against a second step transaction. The flip-over provision would come into play if, after the rights have been triggered, the target was sold or engaged in some other change in control transaction. Under those circumstances, each right then outstanding would “flip over” and become a right to buy shares of the raider’s common stock with a market value equal to twice the exercise price of the right.
Like the flip-in provision, the deterrent effect of the flip-over provision depends on its dilutive effect on ownership interests. However, in contrast to the flip-in provision, which dilutes the buyer’s interest in the target company, the flip-over provision dilutes the interest of the buyer’s shareholders in the buyer itself.
Last week, the Ministry of Commerce of the People’s Republic of China blocked Coca-Cola’s proposed acquisition of a major domestic juice manufacturer (China Huiyuan Juice Group Limited) under a recently enacted Anti-Monopoly Law. This is the Ministry’s first significant decision applying the AML to a foreign acquisition of a domestic Chinese firm.
The Ministry of Commerce concluded that the acquisition would adversely affect competition in – and the development of – the Chinese juice beverage market. In particular, the Ministry raised concerns that, as a result of Coca-Cola’s strength in the carbonated beverage sector, the transaction could give rise to potential anticompetitive effects from bundling and tying practices.
Although it’s too early to predict with much certainty – since this case was complicated – this decision points to the possibility that the Ministry may be more protective of the independence of Chinese companies compared to other antitrust authorities around the world. We have posted memos regarding this decision in our “Antitrust” Practice Area.
Last Friday, the FASB held a roundtable to discuss disclosure of certain loss contingencies. This handout shows the issues that were discussed, as the FASB is redeliberating last year’s proposed revisions to FAS 5 and FAS 141(R).
Among others, the issues in this redeliberation have implications for the “Treaty” between the ABA and the AICPA on lawyers’ responses to auditors’ requests for information on pending and threatened litigation and unasserted claims under FAS 5. Here are notes from the roundtable from Sanford Lewis. Any day now, it is expected that the FASB will issue a FASB Staff Position on FAS 141(R) on these issues in connection with business combinations since the FASB voted to do so at the end of February.
Below is a summary of what we can expect from Wilmer Hale:
In amending SFAS 141R, the FASB decided to “carry forward” the prior standard for recognition of contingencies under FASB Statement No. 141, Business Combinations (SFAS 141). Companies will now be required to recognize assets acquired and liabilities assumed in a business combination that arise from contingencies at fair value, if fair value can be reasonably estimated. If fair value of such an asset or liability cannot be reasonably estimated, the asset or liability would be recognized in accordance with FASB Statement No. 5, Accounting for Contingencies (SFAS 5), and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss. It is expected that most litigation contingencies assumed in an acquisition will be recognized only if a loss is probable and the amount of the loss can be reasonably estimated.
Last year, the FASB proposed the FSP in response to concerns about various provisions of SFAS 141R applicable to contingencies. Members of the legal community expressed concerns about the standards as they applied to litigation contingencies, in particular, the requirements that contingencies be recognized at their acquisition-date fair value if it was “more likely than not” that a loss had occurred. The FASB’s proposed FSP would have largely reinstated the prior standard for recognition under SFAS 141, but with amplifications and changes to other aspects of the standard. At its February meeting, the FASB decided to carry forward SFAS 141 without significant revision, thereby leaving many of the issues considered in the proposed FSP for another day.
The FASB also amended the disclosure requirements in SFAS 141R to eliminate the requirement to disclose an estimate of the range of outcomes of recognized contingencies at the acquisition date. For unrecognized contingencies, the FASB will require only that entities include the disclosures required by SFAS 5 and that those disclosures be included in the business combination footnote.
The FSP will have the same effective date as SFAS 141R, and therefore will be effective for all business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 (January 1, 2009, for calendar year-end companies).
The FASB plans to issue the final FSP in March 2009. Companies that have closed or expect to close business combinations in the first quarter of 2009 should pay careful attention to the impact of the amended standard on contingencies that may be acquired or assumed in the transaction.
Tune in tomorrow for this webcast – “The SEC Staff on M&A” – to hear all the latest from:
– Michele Anderson, Chief, SEC’s Office of Mergers & Acquisitions
– Dennis Garris, Partner, Alston & Bird LLP and former Chief, SEC’s Office of Mergers & Acquisitions
– Jim Moloney, Partner, Gibson Dunn & Crutcher LLP and former Special Counsel, SEC’s Office of Mergers & Acquisitions
This March-April issue of the Deal Lawyers print newsletter was just sent to the printer and includes articles on:
– Lessons from the Meltdown: Remedies
– Poison in a Pen: Recent Trends in Drafting Shareholder Rights Plans
– The Ultimate Takeover Defense? RiskMetrics’ New View on Net Operating Loss Poison Pills
– Delaware Upholds Private Equity Deal Structures
– Recent Developments under the Delaware Short-Form Merger Statute
– Section 13(d): The Challenges of “Group Membership”
If you’re not yet a subscriber, try a 2009 no-risk trial to get a non-blurred version of this issue for free.
Remember the scene in “Planes, Trains and Automobiles” where John Candy and Steve Martin are driving the wrong way down an interstate highway? A couple driving in the adjacent lane roll down their window and repeatedly scream “you’re going the wrong way!!” in an effort to get them to turn around. Candy and Martin ignore their warnings, only to eventually look up and see two semi-trucks bearing down on them at high speed. Hilarity ensues.
I am frequently reminded of this scene when I look at the initial draft of a merger agreement for a taxable acquisition and find the deal structured as a forward subsidiary merger (i.e., one in which the target merges into the buyer’s merger sub, with merger sub as the surviving corporation). I’m sure there may be some tax or non-tax reasons to structure a taxable transaction in this manner from time to time, but a forward merger usually is not the preferred way to structure a taxable corporate acquisition. In fact, it is usually the worst possible structure for such a transaction.
That’s because – in the strange universe presided over by the IRS – there are no such things as taxable “mergers.” There are taxable stock acquisitions, and taxable asset acquisitions. If the IRS thinks your deal looks like a taxable asset acquisition, you get hit with double taxation (gain is taxed at the corporate and shareholder level).
For the past 40 years, the IRS has taken the position that a forward merger is an asset acquisition subject to double taxation. (If you’re interested, the pertinent authority is Rev. Rul. 69-6, 1969-1 C.B. 104). In contrast, a reverse subsidiary merger (i.e., one in which merger sub is merged into the target, with the target surviving) is treated as a stock acquisition. This is the classic trap for the unwary – and some scholars have argued that the IRS should do away with distinction between forward and reverse mergers, and treat all cash mergers as stock purchases.
It should be noted that when you’re dealing with a tax-free reorganization under Section 368 of the Internal Revenue Code, forward mergers frequently make quite a bit of sense, particularly because you can issue a lot more cash or other non-stock consideration in these transactions than you can in tax-free reverse subsidiary merger.
Putting aside the tax issues, a reverse subsidiary merger structure is often preferable to a forward merger because this structure tends to trigger a lot fewer change of control clauses and consent requirements than does a forward merger structure. Yet despite these tax and non-tax considerations, it’s remarkable how frequently the first draft of deal documents contemplates a forward merger.
Going the wrong way was pretty funny when John Candy and Steve Martin did it, but it’s a lot less amusing if the parties to a merger agreement for a taxable deal do it.
Public company merger agreements frequently contain provisions under which a buyer agrees to cause the surviving corporation to indemnify the seller’s directors to the same extent that they are currently indemnified “or to the fullest extent permitted by law.” While this is pretty standard practice, language like this can provide a seller’s directors with much broader indemnity rights than they would be able to obtain from the seller itself. That is usually good news for a seller’s board, but not always.
That point was brought home last month when a Tennessee appellate court, applying Delaware law, refused to dismiss duty of loyalty claims against a seller’s directors premised on the inclusion of customary director indemnity arrangements in a merger agreement.
In Indiana State District Council of Laborers v. Brukardt, No. M2007-02271-COA-R3-CV (Tenn. App. Feb. 17, 2009) the Tennessee Court of Appeals overruled a trial court’s dismissal of a shareholder class action lawsuit against the board of directors of Renal Care, Inc., a health care company that was acquired by Fresenius Medical Care AG in 2005. Among their other allegations, the plaintiffs contended that the defendants breached their fiduciary duty of loyalty by entering into the merger in order to “cover alleged Medicare fraud and back dating of stock options, [and] also to insure that they would be free of any possible liability for such acts.”
In dismissing the plaintiffs’ loyalty claim, the trial court held that a majority of the Board had no conflicts of interests. The appellate court disagreed, noting that the plaintiffs had alleged that “by engineering the merger which included indemnification, all defendants were able to significantly minimize their exposure to liability in connection with the alleged brewing problems at Renal Care.”
The defendants contended that no conflict of interest existed between the interests of directors and shareholders when the indemnity rights given them under the merger agreement were “essentially duplicative” of rights that they already had, but the court disagreed:
“First as a matter of Delaware law, Renal Care could only indemnify defendants for “acts in good faith and in the best interests of the corporation.”But Fresenius, as a third party indemnifying Renal Care directors, is not bound by “the restrictions of statutory corporate law” and can extend indemnifications to defendants for breaches of the duty of loyalty and good faith.”
In reaching this conclusion, the court cited the Delaware chancery court’s decision in Louisiana Mun. Police Employee’s Ret. Sys. v. Crawford, 918 A.2d 1172, 1180 n. 8 (Del. Ch. 2007). In that case, the chancery court characterized the distinction between the indemnification that a buyer could provide and that which the seller could provide its own directors as being “quietly critical.” In the present situation, the court believed that under Delaware law, “the indemnification offered by Fresenius covers defendants’ liability for option backdating, a breach of the duty of good faith, whereas the indemnification offered to defendants by Renal Care could not.”
Crawford involved the CVS/Caremark transaction and attracted a lot of attention when it was decided. At the time, most of the discussion surrounded the court’s decision that Caremark’s shareholders had appraisal rights in a purported stock-for-stock merger because a special dividend declared in connection with transaction should be considered part of the merger consideration.
The Chancery Court’s discussion of the distinction between the rights to indemnity that a director could obtain from his or her corporation and those that a buyer could provide was confined to a footnote. Nevertheless, as the Tennessee Court of Appeals decision in Laborers v. Brukardt suggests, that footnote may have some pretty important implications for those involved in mergers and acquisitions.
Oddly, I’ve been watching a few of CNBC’s stock market shows lately. I guess I’ve been curious how they’ve been touting stocks in this downturn and it’s been comic relief. And the recent feud between Jon Stewart and Jim Cramer has been absolutely hilarous – and coming to a head tomorrow when Jim appears on “The Daily Show.”
One of the delightful surprises was catching one of my DealLawyers.com advisors, Frank Aquila of Sullivan & Cromwell, on “Fast Money” Monday night (here is a video archive of it). Apparently Frank is a regular guest and he was great riffing on the state of M&A.
His shining moment was dealing with one of the host’s awkward statements that more deals tended to happen during the proxy season as she seemed to be confused about cause and effect. Frank didn’t show her up for her inartful statement (she probably meant that if companies were going to run slates they would have to be going forward right now).
Anyways, I think I’ve gotten CNBC out of my system. Fun while it lasted…
Following up on my earlier blog portraying some “deal cube” chronicles, I’m holding a contest for the coolest cube. Please email me pictures of the cube(s) that you cherish the most. If you wish to remain anonymous, I’ll honor that request as always.
Here are a few more deal toy stories:
– We did a public offering of subordinated debt a number of years back. There was an extensive negotiation with the senior lender regarding the subordination agreement and specifically on the “fish or cut bait” provisions which force the senior lender to exercise remedies or free the subordinated debt holders to exercise their remedies. The cube for the deal was the bones of a fish.
The underwriter only provided one such cube to one of the lawyers in my firm who worked on the deal. Over the next ten years, the cube was stolen from the office of the receiving lawyer multiple times by the other lawyers in the firm who worked on the deal and hidden away, but subsequently retrieved. Eventually, he brought the cube home only to have it stolen again at a firm party that he threw at his house.
– I have a cube from a deal I did about five or six years ago that looks like a miniature suitcase nuke. Some poor junior banker had to carry these things through airports on his way to the closing dinner. It’s a miracle he didn’t end up in Guantanamo in the cell next to “Harold and Kumar.”
More to come. Keep those deal cube stories coming…