Cisco/Starent Merger: Relying Upon Fears of Competitive Harm to Avoid a Pre-Signing Market Check

Cisco and Starent networks announced their all-cash $2.9 billion merger on October 12, 2009. The deal proceeded apace, with a plaintiffs’ class-action lawsuit dutifully filed in early November, settled within one month, Starent’s stockholders approving the merger on December 11, antitrust clearance obtained on December 16, with the merger closing on December 18. Very efficient. Now on to the next one.

A review of the background of the merger, however, as disclosed in Starent’s definitive proxy statement of November 9, 2009 circulated to its stockholders in connection with the special meeting called to approve the merger, squarely raises the question of the appropriateness of relying upon a fear of competitive harm to avoid any pre-signing market check. Unfortunately for those of us interested in M&A doctrine, as enunciated by the Delaware courts, prompt settlement of the legal challenge to the deal will leave resolution of that question to another day.

A. Background of Cisco’s Acquisition of Starent

This deal had its germination in a June 2009 meeting between Starent’s CEO, Ashraf Dahod, and representatives of Cisco to discuss a potential global reseller arrangement between the parties. Simultaneously, Starent commenced discussions with another firm in its industry concerning a possible strategic alliance with respect to the development and sale of certain products. Starent called upon Goldman Sachs, which underwrote Starent’s IPO in 2007, to impress upon Cisco the need to move quickly on negotiations over a reseller arrangement “in light of other strategic alternatives being considered by Starent.” For reasons not explained, Starent’s formal engagement of Goldman, as its financial advisor in this deal, was not formalized until September 23, 2009.

Cisco got down to business in meetings between the parties on August 9 and 10, expressing an interest to Dahod of exploring a possible business combination with Starent. The Starent board met on August 10 and, according to Starent’s proxy statement, made the ritualistic determination “that for the time being Starent should continue to pursue its business plan as an independent company.” No Revlon trigger here. At this very first board meeting to consider a possible deal, the strategy of avoiding a market check of Starent’s value or any auction of Starent was adopted:

“Our board of directors also discussed the potential harm to our business that might result if current or potential customers or competitors were to become aware that we were considering a possible business combination, and our board of directors concluded that there was a need to maintain the confidentiality of any acquisition discussions in order to avoid the potential for such harm, particularly in view of the uncertainty that Starent and Cisco would ever reach an agreement with respect to a business combination.”

Proxy Statement at 17.

The proxy statement does not state, in its description of this first board meeting on a possible deal, that either Goldman or Starent’s counsel participated in the meeting, which is odd since one would think each might have had a view on the board’s conclusion.

Discussions continued apace between Starent and Cisco in early and mid-August. The board met again on August 19. Clearly anticipating an offer from Cisco, the board “considered the possibility of engaging in discussions with other potentially interested parties.” The board confirmed its decision not to engage in discussions with any other potentially interested party:

“Our directors discussed the likely interest of other potentially interested parties in a business combination, as well as the possible ramifications to Starent if competitors or customers were to become aware of any such discussions. Our directors determined that given the preliminary nature of the discussions with Cisco and the potential competitive harms and risk to the alternative strategic alliance under discussion with Company Y, it was not in the best interests of Starent and its stockholders to initiate such discussions at this time, but that the directors would continue to evaluate the advisability of such actions as the discussions with Cisco evolved.”

Proxy Statement at 18.

Again, no mention of Goldman’s or counsel’s participation in this discussion, and no specification of the “potential competitive harms.”

Six days later, the board met again to review the now obviously intense discussions going on between Starent and Cisco. The board again records its decision not to pursue discussions with any other party about a deal:

“There was also discussion at this meeting as to specific other parties that might be interested in a business combination or strategic transaction with Starent and the business issues that would arise if we were to approach other possibly interested parties as to a business combination or other strategic transaction, including specifically the significant potential business risks to Starent that might arise if competitors or customers were to learn that Starent was exploring a sale of its business. The directors concluded that, given the potential for harm to Starent’s business and the jeopardy to its strategic alliance discussions, other potentially interested parties should not be approached at that time and that the issue would be reconsidered if and when Starent were to receive a business combination proposal from Cisco at a value that our board of directors viewed as sufficient to warrant further exploration.”

Proxy Statement at 18.

Again, no mention of Goldman or counsel, and no detail on the “business risks” feared.

Cisco showed its preliminary hand on September 4, 2009, offering in a telephone conversation a price of $27 per share, subject to further due diligence. (The final deal price was at $35 per share.)

On September 8, 2009, Starent entered into an indemnification letter with Goldman. This too is a bit odd given that the formal engagement letter was not entered into until some 15 days later, on September 23. Why not enter into both agreements at the same time (typically the bankers’ indemnification is set out in or in an exhibit to the engagement letter)?

The Starent board rejected Cisco’s preliminary proposal on September 8. In response, Cisco did the obvious, and invited Starent’s management to Cisco’s offices “to explain why Starent’s business and prospects merited a higher price.” After this dog-and-pony show, Cisco upped the ante on September 21, raising its price to $33 per share.

The Starent board met on September 21, and concluded that $33 was “insufficient.” But obviously the end game was near, so what did the directors decide about conducting a market check? No surprise —

“The directors also discussed other parties that might be potentially interested in a business combination. Our board of directors requested that management and Goldman Sachs prepare an assessment of other potentially interested parties. The directors also discussed possible different sales processes that might be pursued if our board of directors were ultimately to determine to pursue a sale of Starent.”

Proxy Statement at 19.

But why request of management and Goldman Sachs “an assessment” of other potentially interested parties if the board had concluded, on August 25, that engaging other parties in deal discussions would pose “significant potential business risks to Starent”? And what about Company Y?

“Our board of directors also discussed the possibility of contacting Company Y with respect to its interest in a possible business combination transaction. Our board of directors concluded that, at that time, such a contact could reasonably result in termination of discussions with Company Y as to a potential strategic alliance and, given that the potential alliance with Company Y represented a potentially significant business opportunity and continued to be a reasonably likely outcome, such outcome should not be jeopardized, particularly since it was uncertain whether Starent and Cisco would ever reach agreement on terms for a business combination.”

Id.

It is at this meeting, September 21, 2009, that the board resolves “to engage Goldman to act as Starent’s financial advisor …”! The horse had just about left the barn and now Goldman is retained?

Three days later the board met again and, apparently for the first time, reviewed with Goldman parties that might be interested in a business combination with Starent. The board then made this significant conclusion:

“Our board of directors also reviewed the possibility that a financial buyer might be interested in a potential acquisition of Starent and determine that such interest would be unlikely at a price equal to or greater than the price under discussion with Cisco [$33 per share].”

Proxy Statement at 20.

Did Goldman support this view?

With financial buyers off the table, the board next turned to strategic buyers, and reaffirmed its early (and often) conclusion that the competitive harm in talking to such potential buyers outweighed any potential benefit:

“The directors reviewed again the potential harm that could be inflicted on Starent if the possibility of a business combination were made public or otherwise became known to customers or competitors. After this review, the directors and management concluded that, in light of the potential competitive and business risks to Starent from approaching any other potentially interested party, and the relatively low likelihood that other parties [this reference appears to be to both strategic and financial buyers] would be interested or able to pursue a business combination with Starent at a value exceeding that offered by Cisco, it was not in the best interests of Starent or its stockholders to contact other potentially interested parties about a possible business combination.”

Proxy Statement at 20.

On September 25, Cisco increased its acquisition price to $35 per share, subject to satisfactory completion of due diligence. On September 29, the hammer dropped with John Chambers (Cisco’s CEO) informing Dahod that $35 was it: Cisco would not go any higher.

Starent apparently had one last possibility to test the Cisco proposal, by broaching a possible business combination with Company Y. But, again, the board declined to do so out of fear that doing so would jeopardize the negotiations with Company Y over a strategic alliance. (The board subsequently resolved to negotiate a commercial OEM reseller agreement with Cisco to mitigate the loss of the strategic alliance with Company Y that would occur upon the announcement of any Cisco/Starent merger.)

B. Legal Considerations

I reviewed the Delaware Supreme Court’s decision in Lyondell Chemical Company v. Ryan, 970 A. 2d 235 (2009) in my post of March 30, 2009. In Lyondell, the Delaware Supreme Court reversed Vice Chancellor Noble’s refusal to grant the Lyondell board summary judgment against plaintiffs on the board’s approval of the merger of Lyondell and a subsidiary of Basell AF. In Lyondell, the Court made clear that where a board is disinterested, and the target has included in its certificate of incorporation (as all public Delaware companies now do) a limitation on the monetary damages available against its directors (as permitted by Section 102(b)(7) of the Delaware GCL), then director liability is available only for conduct that is not in good faith, which requires a showing that the directors “knew” that they were not discharging their fiduciary obligations.

There is no reason to conclude from Starent’s description of this deal that the Starent board was conflicted and not disinterested, notwithstanding that eight key employees (including Dahod and five other executive officers) of Starent secured employment agreements with Cisco. Accordingly, a post-closing challenge to this deal would be out of the question. But the teaching of Lyondell does not apply to a request for injunctive relief. In any such request, Revlon principles should apply in full force. The challenge for plaintiffs, therefore, would be to establish that the board of directors of Starent was grossly negligent in not discharging its fiduciary duties under Revlon to obtain the highest price reasonably attainable for Starent’s stockholders.

In their complaint challenging the deal, the closest the Starent plaintiffs came to challenging the Starent board’s reliance upon competitive harm to avoid any market check is a somewhat pro forma allegation that the board failed “to adequately consider potential acquirers, ….” Complaint ¶ 94 (November 3, 2009). The board’s resorting to the tent of competitive harm to avoid any pre-signing market check is not developed in the complaint and, because the case has been settled, the issue will not be joined before the Delaware Chancery Court.

If the issue were joined, then clearly the board’s conclusions would be tested, i.e., what were the nature of the competitive harms feared, and how would specific customers and competitors of Starent react to any rumors that Starent was in play? Surely blanket statements of competitive harm cannot excuse a board from exercising its Revlon duties, as a resort to such fear could virtually eliminate the need for any pre-signing market check.

It would also be of interest to explore in further detail the roles of Goldman and counsel in the board’s deliberations on the competitive harm that would ensue were Starent to talk to other parties about a deal. From a review of Starent’s description of the background of the deal, it appears that Goldman and counsel played little role in these deliberations.

While it might be too much to say that the Starent board got away with one ($35 per share was some three times Starent’s IPO price of two years earlier), the public record of this transaction shows that Cisco had the field to itself. And Cisco is a savvy dealmaker.