HP's Acquisition of 3Com: Another Case of Relying Upon Fears of Competitive Harm to Avoid a Pre-Signing Market Check

On January 26, 2010 the stockholders of 3Com Corporation (“3Com”) (Symbol: COMS) will meet to consider a merger of 3Com into a wholly-owned subsidiary of the Hewlett-Packard Company (“HP”) (Symbol: HPQ) for $7.90 in cash per share. In my post of January 13, 2010, I discussed the reliance by Starent Networks (Symbol: STAR) of fears of competitive harm to avoid any pre-signing market check. While a lawsuit was filed challenging the Starent merger with Cisco, it was promptly settled, and therefore the Delaware Chancery Court had no opportunity to pass upon Starent’s explanation for avoiding a pre-signing market check.

This avoidance rationale is expanding. 3Com voiced similar concerns in avoiding any pre-signing market check of its proposed merger with HP. But in this instance Chancellor Chandler of the Delaware Chancery Court did have an opportunity to address the issue. He did so, albeit obliquely, in rejecting plaintiffs’ request for expedited discovery, concluding, in passing, that 3Com’s failure to solicit other buyers before entering into the merger agreement with HP did not “support a colorable claim that fiduciary duties were breached.” (Letter Opinion of December 18, 2009, at page 12.)

A. Background of the HP Merger

This is the second time to the altar for 3Com. In September 2007 3Com agreed to merge with affiliates of financial buyer Bain Capital, a deal that would have delivered to 3Com’s stockholders $5.30 in cash per share. That deal ran into problems, including with the Committee on Foreign Investment in the United States (CFIUS) and was abandoned in April 2008. The abandonment of the merger let to a shakeup in the senior executive ranks of 3Com, including the appointment of a new CEO and COO.

The proposed marriage with HP began in a familiar fashion, with discussions at a trade show in Las Vegas in May 2009 “concerning a possible commercial relationship.” 3Com’s December 15, 2009 Proxy Statement at 18. Discussions continued over the next few months, during which 3Com reports it was also considering “other strategic initiatives” with “other large technology companies.”

The discussions over a “commercial relationship” ripened into deal talks on July 30, 2009, when HP broached the topic of acquiring 3Com in lieu of establishing a commercial relationship. The next day, July 31, 3Com conferred with its long-time banker, Goldman Sachs, to “discuss the strategic landscape of, and the potential for consolidation in, the networking industry.” Proxy Statement at 19.

HP began the dance on August 5, 2009 with a non-binding indication of interest in the range of $4.80 to $5.15 per share in cash. It requested exclusivity for a 60-day period.

3Com’s board of directors met to consider HP’s indication of interest on August 10, 2009.

I commented in my post on the Cisco/Starent merger that Starent’s description of the background of the transaction was notable for the apparent absence of counsel and Goldman, also Starent’s financial advisors, from key board meetings. Not so with 3Com. At this very first board meeting to consider HP’s interest in acquiring 3Com, 3Com’s counsel, Wilson Sonsini, attended the meeting and “advised the board regarding its fiduciary duties in connection with its consideration of HP’s August 5th indication of interest.” Proxy Statement at 19. The board also decided to engage Goldman to act as its financial advisor in evaluating the HP proposal, “including strategic alternatives to a potential acquisition by HP.”

Also at this first meeting on August 10, Messrs. Mao (CEO) and Sege (COO) discussed for the board management’s “ongoing evaluation and discussions with other companies concerning potential strategic and commercial partnerships.” Proxy Statement at 19.

Goldman joined the board at its August 10th meeting. The board naturally rejected HP’s preliminary indication of interest, “but authorized our senior management team and financial advisor to continue discussions with HP regarding a potential acquisition by HP and to provide additional information to HP to support a higher purchase price for 3Com.” Proxy Statement at 20.

3Com, like Starent, concluded that seeking alternative indications of interest at this stage was not prudent:

“After discussion among the board members, the board determined not to seek alternative indications of interest to acquire 3Com from other companies at this time due to the preliminary nature of HP’s indication of interest, the relatively wide divergence in views between the board and HP over 3Com’s valuation, and the significant risks of harm to 3Com’s business and of employee dislocation if speculation arose that 3Com was considering a transaction with potential acquirors.”

Proxy Statement at 20.

This explanation has a familiar ring, although one might ask how 3Com’s competitors and interested parties could not know that 3Com was in play given that it had spent seven months, over the period September 2007 through April 2008, trying to consummate a merger with Bain Capital?

3Com provided additional due diligence information to HP in August and September of 2009. HP bided its time. On September 23, the board held a regularly scheduled meeting. Representatives of Goldman attended and, in the context of a review of the discussions with HP, “discussed other strategic opportunities that could be under consideration by HP as potential alternatives to an acquisition of 3Com.” Proxy Statement at 20. Goldman also discussed the “potential interest of other technology companies in acquiring 3Com.” Id. at 21. Wilson Sonsini advised the board “regarding its fiduciary duties in connection with its evaluation of strategic alternatives, including a possible acquisition by HP or any other acquirer.” Id.

With HP’s eyes apparently wandering, now was the time for the 3Com board to put out feelers to other technology companies, assuming 3Com had an interest in pursuing a deal. But it did not do so, even after learning, on October 5 from published reports, that HP might be interested in acquiring one of 3Com’s competitors.

But the only suitor 3Com had an interest in was HP, and finally that desire bore fruit, for on October 19, HP upped its proposed purchase price to $6.75 per share. The board met to consider this offer the following day, and conducted the standard reviews, including of remaining independent. The board resolved to reject HP’s indication of interest, but instructed Mao to advise HP to consider increasing its proposed purchase price to between $8.00 and $8.50 per share, and to inform HP that 3Com “would consider a brief period of exclusive negotiations at a price in this range.” Proxy Statement at 22. At this meeting the board appointed a transaction committee to oversee discussions with HP “or potentially other parties” and to report regularly to the board.

HP edged closer to the altar on October 25, upping the ante to $7.80 per share (the final deal price was $7.90 per share). The board met the following day, October 26, to consider HP’s offer. The board concluded that HP’s offer was “attractive” but instructed management to make one more try.

Quite obviously at this stage it would be a bit late to seek third-party indications of interest. Rather than rely upon concerns of competitive harm to avoid doing so, however, the board now concluded that “very few” companies with the financial resources to acquire 3Com would have an interest in doing so!

“After this discussion [whereby Goldman Sachs discussed other large technology companies that would be reasonably likely to have an interest in 3Com], the board determined that there were few companies that would likely have a strategic interest and sufficient financial resources to consider an acquisition of 3Com. The board further noted that 3Com had been engaged in ongoing discussions with certain of these companies regarding commercial relationships for some time, but none of them had expressed any interest in discussing an acquisition of 3Com at this time. Moreover, the board noted that the press had extensively reported on acquisition trends and likely targets of consolidation in the networking industry (including one of our primary competitors and 3Com itself), but that no companies had approached 3Com to discuss a potential acquisition in light of such press reports.”

Proxy Statement at 23.

Accordingly, the board resolved not to pursue any other potential acquirors and to enter into an exclusivity agreement with HP for a limited duration. HP made its final and best offer of $7.90 per share on October 26. This price, and the definitive merger agreement, were approved by the board on November 11.

B. The Plaintiffs’ Challenge of the Deal

The primary focus of plaintiffs’ complaint against 3Com is on purported disclosure violations, which is understandable since a disclosure violation automatically constitutes irreparable harm entitling plaintiffs to injunctive relief. The plaintiffs spent considerable effort in trying to establish material omissions in the proxy statement involving Goldman’s valuation and the description thereof. Plaintiffs also alleged that the process followed by 3Com in agreeing to the HP merger was flawed and constituted a breach of the board’s fiduciary duties to 3Com’s stockholders. And while plaintiffs do not allege that the reasons given by 3Com’s board to pass on conducting a market check prior to the signing of the HP merger agreement were pretense, plaintiffs allege, repeatedly, that “3Com negotiated exclusively with HP and never contacted any other potential bidder.” Consolidated Amended Complaint ¶ 46 (dated December 11, 2009). Plaintiffs make similar charges in paragraphs 47, 73, 74, and 80(a) of the Complaint. They allege in paragraph 73:

“. . . the terms of the Merger were not the result of an auction process or active market check; they were arrived at without a full and thorough investigation by the Individual Defendants [the executive officers and directors of 3Com] of strategic alternatives; . . .”

So the Chancellor, in ruling on plaintiffs’ request for expedited discovery, clearly had before him the charge that the 3Com board did nothing to conduct a pre-signing market check before agreeing to a deal with HP at $7.90 per share.

C. The Chancellor’s Decision

Chancellor Chandler ruled on plaintiffs’ request for expedited discovery by his letter opinion of December 18, 2009. The test, as stated by the Chancellor, in resolving plaintiffs’ request was whether they had alleged in their complaint “a sufficiently colorable claim [and have shown] a sufficient possibility of threatened irreparable injury, as would justify imposing on the defendants and the public the extra (and sometimes substantial) costs of an expedited preliminary injunction proceeding.” Letter Opinion at 1-2.

The Chancellor concludes that plaintiffs had not met this test. With respect to their disclosure claims, he essentially concludes that the plaintiffs were nit picking, and that 3Com had done all that Delaware law requires to explain the basis for the board’s decision to proceed with the merger with HP and had accurately summarized Goldman’s valuation analysis and its limitations. As the Chancellor observed in responding to plaintiffs’ claim that Goldman’s fairness opinion deviated from conventional practice and that such deviations should have been disclosed:

“Under Delaware law, the valuation work performed by an investment banker must be accurately described and appropriately qualified. So long as that is done, there is no need to disclose any discrepancy between the financial advisor’s methodology and the Delaware fair value standard under Section 262 (or any other standard for that matter).”

Letter Opinion at 10 (footnotes omitted).

In conclusion, observed the Chancellor, the plaintiffs’ “quibbles with Goldman’s methodologies (and inputs into those methodologies), if they are serious, can be resolved via an appraisal action.” Id. at 11.

The bulk of the Chancellor’s decision is devoted to plaintiffs’ disclosure claims (11 of 12 pages) — he gives short shrift to plaintiffs’ breach of fiduciary duty claims, and groups them together: Plaintiffs, he observes, have alleged that the 3Com directors breached their fiduciary duties by —

“(a) including a no-solicitation and matching rights provision in the Merger agreement, (b) including a $99 million termination fee, that, along with a $10 million expense reimbursement fee represents over 4% of the equity value of the Merger, and (c) failing to make an effort to solicit other buyers before entering the Merger agreement.”

The Chancellor concluded that “none” of these allegations “support a colorable claim that fiduciary duties were breached.” Letter Opinion at 12.

While the Chancellor cites authority for his conclusion as to plaintiffs’ “deal protection” allegations, he cites none for the proposition that a target need not solicit other buyers before entering into a merger agreement. Perhaps it was obvious to him.

D. Whither Pre-Signing Market Checks?

Perhaps in passing upon pre-signing market checks, Starent and 3Com took their cue from the Delaware Supreme Court’s decision in Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (2009), which I discussed in my post of March 30, 2009. The board of Lyondell did not conduct a pre-signing market check before agreeing to a deal with Basell AF at $48 per share, a number Lyondell’s banker, Deutsche Bank, concluded was “an absolute home run.” But Vice Chancellor Noble was clearly bothered by the Lyondell board’s failure to conduct any pre-signing market check, and the speed with which the board approved the deal, in denying defendants’ motion for summary judgment.

The Delaware Supreme Court reversed the Vice Chancellor and directed entry of summary judgment for the defendants. One of the key findings of the Court was that Vice Chancellor Noble had selected too early a date for the invocation of Revlon duties — the announcement of the filing of a Schedule 13D by Basell rather than the later point in time at which the board resolved to seriously consider a sale of the company. Because Lyondell involved a post-closing challenge to a merger, and Lyondell had an exculpatory provision in its certificate of incorporation, plaintiffs had to establish a lack of good faith by the directors (which is non-exculpatory) to prevail. The Court in Lyondell confirmed that to establish a lack of good faith requires establishing that the directors knew that they were not discharging their fiduciary obligations.

In reversing Vice Chancellor Noble, the Delaware Supreme Court noted that the Lyondell directors were active, sophisticated, and generally aware of the value of the company and the conditions of the markets in which the company operated (970 A.2d at 241, and that they “had reason to believe that no other bidders would emerge, given the price Basell had offered and the limited universe of companies that might be interested in acquiring Lyondell’s unique assets.” Id. Moreover, Lyondell’s CEO negotiated Basell’s offer from an initial price of $40 to $48 per share, a 20% increase. And, noted the Court, “no other acquiror expressed interest during the four months between the merger announcement and the stockholder vote.” Id.

Crucial to its analysis, the Court noted that Revlon duties (to obtain the highest price reasonably available) “applies only when a company embarks on a transaction — on its own initiative or in response to an unsolicited offer — that will result in a change in control.” Id. at 242.

And the Court went out of its way to emphasize the discretion a board has in discharging its Revlon duties:

“There is only one Revlon duty — to ‘[get] the best price for the stockholders at a sale of the company.’ No court can tell directors exactly how to accomplish that goal, because they will be facing a unique combination of circumstances, many of which will be outside their control. As we noted in Barkan v. Amsted Industries, Inc., ‘there is no single blueprint that a board must follow to fulfill its duties.’ ”

970 A.2d at 242 – 243 (footnotes omitted).

In language that clearly gives comfort to those who believe a pre-signing market check is not necessary under Revlon, the Court responded in this way to Vice Chancellor Noble’s concerns about the failure of the Lyondell board to conduct an auction or market check pre-signing:

“The Lyondell directors did not conduct an auction or a market check, and they did not satisfy the trial court that they had the ‘impeccable’ market knowledge that the court believed was necessary to excuse their failure to pursue one of the first two alternatives [conduct an auction or a market check]. As a result, the Court of Chancery was unable to conclude that the directors had met their burden under Revlon. In evaluating the totality of the circumstances, even on this limited record, we would be inclined to hold otherwise. . . . Where, as here, the issue is whether the directors failed to act in good faith, the analysis is very different, and the existing record mandates the entry of judgment in favor of the directors.”

970 A.2d at 243 (emphasis added).

An evaluation of a board’s discharge of its fiduciary duties, particularly in a deal context, is heavily contextual. But the records of the Cisco/Starent and HP/3Com deals contain facts similar to those involved in the Basell/Lyondell deal: large companies experienced in doing deals, advised by competent and experienced advisors; a final merger price that exceed by a material amount the initial bids (30% in the case of Cisco/Starent and 65% in the case of HP/3Com); and, notably, the failure of any third party to jump in after the deal was announced. While deal protection measures and match rights make the prospect of busting up a deal unattractive, it can be done, as EMC’s snatching of Data Domain from NetApp demonstrated. (See my posts of June 10, 24 and 26, 2009 on the battle for Data Domain).

But this much is clear — a board disinclined to conduct an auction or pre-signing market check to validate a price that it negotiates with a suitor has both precedent and Delaware case law to justify its reluctance. And a board can take some comfort in knowing that if it truly misses the boat, a determined party (e.g., an EMC) may jump in and make the board’s error moot.