Fiduciary Outs for Intervening Events: Are They Necessary?

Fiduciary outs to permit a target board to accept a superior proposal are now virtually universal in public M&A deals, particularly after Omnicare (Omnicare, Inc. v. NCS Healthcare, Inc., 818 A. 2d 914 (Del. 2003)), but how about a fiduciary out that permits a target board to change its recommendation in favor of a deal by reason of “intervening” events? The Committee on Mergers and Acquisitions of the ABA’s Section of Business Law gives an example of such a provision in its 2008 “Target Deal Points Study” (M&A Negotiation Trends Involving Public Targets: Insights from the 2008 Strategic Buyer/Public Company Target Deal Points Study):

“Notwithstanding anything to the contrary contained in Section 5.2(b), at any time prior to the approval of this Agreement by the Required Target Stockholder Vote, the Target Board Recommendation may be withdrawn or modified in a manner adverse to the Buyer if: (A)(i) an unsolicited, bona fide written offer… is made to the Target and is not withdrawn… and the Target’s board of directors determines in good faith (based upon a written opinion of an independent financial advisor of nationally recognized reputation) that such offer constitutes a Superior Offer; or (ii) a material development or change in circumstances occurs or arises after the date of this Agreement [that was not known by the Target’s board of directors as of the date of this Agreement] (such material development or change in circumstances being referred to as an “Intervening Event”), and (B) the Target’s board of directors determines in good faith … that, in light of such Superior Offer or such Intervening Event, the withdrawal or modification of the Target Board Recommendation is required in order for the Target’s board of directors to comply with its fiduciary obligations to the Target’s stockholders under applicable law …”

Slide 50 (emphasis in original).

Based upon a sample of 152 transactions studied (of acquisitions of publicly-traded targets by publicly-traded and other strategic buyers for transactions announced in 2007, excluding acquisitions by private equity buyers), the M&A Committee reports that 52% of the deals permitted the target board to change its recommendation in the exercise of its fiduciary duties (7% based upon the occurrence of an intervening event or superior offer and 45% in the exercise of the board’s fiduciary duties and not limited solely to a superior offer or the occurrence of an intervening event). Deal Points Study, slide 51.

A. What’s the Point?

A deal is a deal. Why permit a target board to change its recommendation (and presumably torpedo stockholder approval of the deal) on such nebulous grounds as the occurrence of a “material development” or a “change in circumstances” since the deal was inked, particularly given the amount of time and effort that goes into negotiating a merger agreement and preparing the necessary disclosures? This out strikes one as bordering on the ridiculous.

The source of this provision lies in the nature of a merger agreement (including a two-step merger agreement involving first a tender offer and then a back-end merger). A merger agreement requires stockholder approval (unless the target is 90% or more owned by the acquiring corporation). By reason of this requirement, “[t]he directors of [the target are] under continuing fiduciary duties to the shareholders to evaluate the proposed transaction.” Frontier Oil Corporation v. Holly Corporation, 2005 WL 1039027 at * 27 (Del. Ch. 2005). As Vice Chancellor Noble emphasized in this decision:

“Revisiting the commitment to recommend the Merger was not merely something that the Merger Agreement allowed the Holly Board [the target] to do; it was the duty of the Holly Board to review the transaction to confirm that a favorable recommendation would continue to be consistent with its fiduciary duties.”

Id. at * 28. See also id. at * 29 (“They [Holly’s Board], of course, will require, as a matter of fiduciary duty, to continue their assessment of whether to recommend the Merger to Holly’s shareholders.”).

If, then, a target board’s recommendation to stockholders to approve a deal speaks not only as of the date the board met to approve the merger agreement, but also continues to the actual vote of stockholders on the deal, then the board has no choice but to take into account events that have transpired or “intervened” since the date of the meeting at which the board approved the transaction.

B. What Kind of “Intervening Events” Matter?

This observer is not aware of any cases that directly address what kind of “intervening events” (other than a superior proposal) would justify a board in changing its recommendation to stockholders to approve a contractually agreed-upon deal. The Frontier/Holly case itself offers two potential candidates, namely, litigation involving the acquiror (Frontier Oil) which, while the parties were aware was a potential claim on signing, blew up into major litigation after signing, and a discovery, post-signing, that Holly’s assets were much more valuable than understood by the Holly board at the time of signing. Vice Chancellor Noble appears to assume, in his decision, that these two events would have justified the Holly board in withdrawing its recommendation to the Holly stockholders to approve the Frontier/Holly deal. However, he concluded, nevertheless, that neither the blowup of the litigation nor Frontier’s failure to disclose a guaranty of its subsidiary’s lease obligations (thus leading to Frontier’s being named as a defendant in the litigation) constituted a “material adverse effect” or a material rep and warranty breach that would have justified Holly in terminating the merger agreement.

Another potential candidate for an “intervening event” justifying a change in an approval recommendation would be positive news for a drug company conducting clinical trials of a new drug. A good example is Genentech’s Avastin (colon cancer), whose clinical trials clearly motivated the Genentech board in “slow playing” its negotiations with Roche. Once the parties resolved their differences, the final two-step merger agreement between the parties explicitly excluded from the definition of a Genentech “material adverse effect,” “the results of the Avastin … adjuvant colon cancer trial ….”

C. What Difference Does the Board Recommendation Make?

With a truly positive “intervening event” a board recommendation for approval of a deal would be beside the point. If, say, Holly, between signing and the Holly stockholder vote, announced a mega oil discovery, with the result that its stock price quintupled, what difference would a board recommendation to approve the deal with Frontier make? Stockholders would vote the deal down, particularly if, as is typically the case, arbs come to own a significant percentage of the target’s stock. So in this sense a provision allowing a board, in obeisance to its fiduciary duties, to change its approval recommendation by reason of intervening events simply acknowledges the obvious: if the world changes between signing and the stockholder vote, the change will affect the stockholder vote.

C. Interplay of MAE Condition and Fiduciary Out

There is also a sense that the broad-form fiduciary out is simply the converse of allowing an acquiror to withdraw from a deal by reason of the occurrence of a material adverse effect. If by reason of events occurring subsequent to signing (I ignore, for this purpose, breaches of reps and warranties), that materially and adversely affect the target disproportionally the buyer can walk, why not allow the seller to do the same if the opposite occurs, e.g., the wonder drug is approved or the giant oil and/or gas field is proved up?

D. But at What Cost?

A change in board recommendation will typically allow the buyer to terminate the agreement and collect a breakup fee. The typical fee is payable by reason of a termination due to the acceptance of a superior offer, such as just happened with Data Domain and NetApp when EMC busted up their deal. But how about payment of a greater termination fee if a target board changes its recommendation solely based upon an intervening event not involving a superior proposal? That would appear problematic, because it could be viewed as coercive to the stockholders of the target (“approve our deal or else”), and because it might be construed as undercutting the target board’s exercise of its fiduciary duties, as articulated by Vice Chancellor Noble in the Frontier decision.

E. Breaking Up is Easier Said Than Done

As the Frontier case itself demonstrates, and as emphasized by the Delaware Chancery Court’s decisions in Hexion v. Huntsman and IBP, the sensible course to follow in trying to extricate oneself from one of these deals is to let the stockholders do it, i.e., if a target board modifies its recommendation in favor of a deal by reason of an intervening event, the prudent course for the target board (assuming the buyer doesn’t terminate and collect the breakup fee) is to take the deal to the stockholders and let them reject it, if they so choose. Seeking a declaratory judgment from the Delaware Chancery Court permitting a party (buyer or seller) to extricate itself from a fully negotiated contract is, based on the Chancery Court’s decisions to date, an uphill battle.