M&A Litigation Commentary

Pentwater v. BPW Acquisition Corp.; Delaware Chancery Court Unmoved by Strong-Arm Tactics Employed Against Holdout Warrant Holders

2010-04-15T17:08:00.000-07:00

On Friday, March 26, 2010, hedge funds managed by Pentwater Capital Management, L.P. (“Pentwater”) sought a temporary restraining order from Vice Chancellor Strine (i) restraining The Talbots, Inc. (“Talbots”) from closing a pending exchange offer made to the warrant holders of BPW Acquisition Corp. (“BPW”) and (ii) restraining BPW from proceeding with soliciting consents for amendments to the Warrant Agreement governing the outstanding BPW warrants. The Vice Chancellor rejected Pentwater’s application, concluding that Pentwater’s application should have been brought in New York, not Delaware, that its coercion and contract claims were not colorable, that it had not identified irreparable harm that it would suffer if the court failed to restrain Talbots and BPW, and that the balance of the equities weighed against granting any relief.

Talbots’ exchange offer — for 90% of the outstanding BPW warrants — was a condition to a pending merger of Talbots and BPW. The exchange offer crossed the requisite threshold on April 6 and the merger closed on April 7. Following its defeat at the hands of the Vice Chancellor on March 26th, Pentwater voluntarily dismissed its complaint.

The focus in this post is on the contractual claims asserted by Pentwater, including its claim for violation of the implied covenant of good faith and fair dealing inherent in all contracts. While the Vice Chancellor found Pentwater’s contractual claims not colorable, I think the better argument is that they have merit. (Full disclosure: I represented a group of hedge funds that had a position in the BPW warrants but, after Pentwater’s defeat, folded their tent and participated in the exchange offer.)

Pentwater pursued a risky strategy, namely, seeking to enjoin not only BPW’s consent solicitation but also Talbots’ exchange offer. It also confronted substantial questions as to its selection of venue (Delaware v. New York), the question of whether damages were an adequate remedy, and on the balance of the equities. Had these factors not been present, Pentwater’s contractual claims might very well have received a more receptive audience. Perhaps they may still be, by Pentwater (if it retained any BPW warrants) or by those holders of the BPW warrants who did not participate in the exchange offer.

A. Background

BPW was a poor man’s hedge fund, a so called “SPAC” or special purpose acquisition company. The idea of SPACs was to marry money with smart deal finders. The money was raised with no specific investment in mind, other than in a general industry. Once the smart guys found a good investment opportunity (and they had a limited amount of time to do so) they would present it to the shareholders of the SPAC for approval. If a sufficient number of the shareholders did not approve the acquisition, electing instead for a return of their cash, then the company would liquidate and return the offering proceeds (minus expenses) to the shareholders. Needless to say, with the Great Recession and its impact on hedge funds, the bloom is off SPACs.

BPW conducted its offering in February 2008, raising $350 million through the sale of 35 million units (“Units”), consisting of one share of BPW common stock and one warrant. The warrants were designed to trade separately from the common shortly. BPW was sponsored by Perella Weinberg Partners Acquisition LP (“Perella Weinberg”) and BNYH BPW Holdings, LLC (the investment vehicle of the Lerner family of New York). BPW was to focus on one or more deals in the financial services or business services industries but, of course, the prospectus, having been drafted by lawyers, allowed BPW to pick a deal with any business (the consummation of which would require shareholder approval).

The BPW warrants would not be exercisable unless and until BPW did a deal, and would be exercisable from and after that point until six years from the date of the IPO prospectus (or until February 26, 2014). The warrants were exercisable for one share of BPW common at $7.50 per share.

Talbots, the women’s apparel company, had been suffering from declining sales and heavy debt. Its Japanese majority shareholder and primary lender, AEON Co., Ltd. (“AEON”) was chafing. Talbots retained Perella Weinberg in early 2009 to advise it on refinancing its debt. In the fall of 2009, AEON notified Talbots that it wanted to divest its Talbots debt and its equity interest in Talbots. This, of course, meant that Talbots was in play, so Talbots broadened Perella Weinberg’s portfolio to include “alternative strategic transactions” as well as refinancing transactions that would address Talbots’ upcoming debt maturities.

Surprise! Perella Weinberg, at the instruction of Talbots’ audit committee, sought out several SPACs, including BPW, for a potential deal with Talbots, since SPACs had what Talbots needed — cash. BPW emerged as Talbots’ merger partner, no doubt in no small part because of Perella Weinberg’s sponsorship of BPW and continued significant influence over it (Joseph Perella himself served as Vice Chairman of the BPW board and other Perella officers served in BPW’s management, including Gary Barancik, BPW’s CEO and a partner of Perella Weinberg).

So Talbots and BPW entered into a merger agreement in December 2009 pursuant to which a wholly-owned subsidiary of Talbots would merge with and into BPW, with BPW as the surviving entity and a wholly-owned subsidiary of Talbots. (For reasons not entirely apparent, on April 6, the day before the merger closed, the parties amended the merger agreement to provide that, immediately following the merger, by a short-form merger, BPW would merge with and into Talbots.) Each BPW shareholder would receive Talbots’ shares, in accordance with a formula, designed to deliver to them Talbots’ shares with a value of approximately $11.25 (BPW’s Units were sold in its IPO at $10 per Unit). (As consummated, the exchange ratio was 0.9853 Talbots’ shares for each common share of BPW.)

What to do with the BPW warrants? The BPW warrants, if simply assumed by Talbots in a merger, would be dilutive to the shareholders of Talbots (a warrant with an exercise price of $7.50 is in-the-money for Talbots’ shares trading at $11.25) but the BPW warrant holders could be muscled since the warrants would expire worthless if BPW did not do a deal by its deal deadline — February 26, 2010 (which was extended by the shareholders of BPW to April 26, 2010 in connection with their approval of the Talbots merger). The upshot was a condition to Talbots’ obligation to proceed with the merger, namely, that at least 90% of the holders of the BPW warrants accept Talbots’ common shares or newly-issued Talbots’ warrants. The Talbots warrants would carry an exercise price greater than the $7.50 exercise price of the BPW warrants (adjusted for the exchange ratio of the Talbots/BPW shares in the merger) — the Talbots warrants were priced to be some 30% out-of-the-money based upon Talbots’ common share price used to determine the exchange ratio. Talbots launched its exchange offer to implement this condition to the merger on March 1, 2010, with the definitive version of the exchange offer prospectus dated March 11, 2010.

Talbots stated in the exchange offer prospectus that those BPW warrant holders who did not participate in the offer would “in accordance with the terms of the existing warrant agreement governing the BPW Warrants, be converted into warrants to purchase the number of shares of Talbots’ common stock that such warrant holder would have received in the merger had the BPW warrants been converted to shares of BPW common stock immediately prior to the completion of the merger.” Exchange Offer Prospectus at p. 46. So, based on an exchange ratio of 0.9853 share of Talbots’ common for each share of BPW’s common, BPW warrant holders who held their warrants would be able to purchase Talbots’ common at $7.61. The holders of such warrants, instead of being out-of-the-money by some 30% if they exchanged for Talbots’ warrants, would be in-the-money by some $3.64 (assuming a Talbots’ common price of $11.25). (Talbots closed on March 14 at $15.17.)

This presented an arbitrage opportunity — buy BPW warrants (perhaps combined with some short selling of Talbots’ common). Undergirding this strategy was the assumption that capturing BPW’s $350 million in cash was simply too attractive to Talbots and its majority shareholder, AEON, so that, when push came to shove, Talbots would waive the 90% condition, purchase whatever number of warrants were tendered into the exchange offer, and close the merger with BPW.

Clearly such arbitrage occurred, to the chagrin of Talbots and its advisors, so they come up with a strategy to “persuade” the holdouts to participate in the exchange offer.

B. The March 16 Consent Solicitation

Some two weeks after Talbots launched its exchange offer, BPW filed its preliminary proxy statement with the SEC seeking the consent of the BPW warrant holders for amendments to the Warrant Agreement. The amendments clearly were not in the interest of those warrant holders who had elected or would elect not to participate in the exchange offer, as they would (i) defer the exercise period of the BPW warrants for one year after consummation of the merger between Talbots and BPW, and (ii) remove all anti-dilution protection from the BPW Warrant Agreement for post-merger stock splits and like events involving Talbots’ common stock.

Why would any BPW warrant holder in his, her or its right mind consent to these proposed amendments? Answer: Those who had already tendered or who had decided to tender into the exchange offer, believing that Talbots meant it when it conditioned the BPW merger upon satisfaction of the condition that at least 90% of the BPW warrant holders participate in the exchange offer, or those who also owned BPW common stock and wanted the deal done as holders of BPW common, and/or hedge funds and institutional investors who responded to the entreaties of Perella Weinberg. Whatever their motivations, BPW announced, on March 25, that it had received (non-binding) statements of support for the proposed amendments from over 50% of the warrant holders, thereby virtually clinching its proposal to amend the Warrant Agreement and putting significant pressure on the holdouts to tender into the exchange offer.

C. Pentwater Objects

Pentwater was one of the holdouts. It filed suit in Delaware Chancery Court objecting to the consent solicitation, claiming it was coercive and a violation of the Warrant Agreement and BPW’s implied covenant of good faith and fair dealing, inherent in all contracts. At least in hindsight, Pentwater’s decision to seek immediate injunctive relief, including an order enjoining consummation of the exchange offer (scheduled to expire the evening of the hearing) was a mistake. BPW’s able counsel (Wachtell Lipton & Morris Nichols) set the stage well in their brief (prepared in some 24 hours) opposing Pentwater’s application for a TRO:

“Plaintiffs are a group of hedge funds and warrantholders of BPW who seek to extract hold-up value by blocking the proposed merger of BPW and Talbots . . . .

Plaintiffs . . . recently accumulated about 9% of the outstanding BPW warrants. Plaintiffs have explicitly stated that they intend to hold their warrants out from the Exchange Offer. If plaintiffs follow through on that threat and are joined by holders of a relatively small number of additional warrants, then all 35 million public BPW warrants, including plaintiffs’ 3.3 million warrants, will expire worthless. Of course, plaintiffs do not seek that economically irrational result. What plaintiffs want instead is to walk away with a better deal than the other warrantholders — to capture for themselves all ten percent of the warrants that need not be exchanged and to extract still further benefits. As a result, plaintiffs are now playing a game of ‘chicken,’ in which they risk to drive the entire body of warrantholders over the cliff. To use the more familiar law-and-economics metaphor, the case presents a ‘hold up’ problem, in which a single resisting investor seeks to take a value-maximizing deal hostage in order to extract end-gain benefits for itself.”

Defendants’ Corrected Opposition, dated March 25, 2010 (“Opposition”) at pages 1, 3.

To further isolate Pentwater, counsel advised the court that if the merger were to fall apart, “BPW will liquidate according to the terms of its charter on April 26 and Talbots may well be doomed to bankruptcy.” Id. at 2.

It was downhill from there for Pentwater, whose counsel, John Reed of Edwards Angell Plummer & Dodge LLP, faced a decidedly skeptical audience for his claims in Vice Chancellor Strine.

But Pentwater’s contractual claims, and one other that it did not raise, are, to this commentator, persuasive. So let me now address these.

D. The Minority Protection Provisions of BPW’s Warrant Agreement

The BPW Warrant Agreement is amendable by the holders of warrants exercisable for a majority of BPW’s common shares subject to the outstanding warrants. But the amendment provision of the Warrant Agreement (Section 18) does not stop there. It states that approval must be obtained by a majority of the holders whose warrants “would be affected by such amendment; . . .” (emphasis added.)

What can this limitation mean? It must mean, at a minimum, that not all amendments to the Warrant Agreement are subject to approval by a majority in interest of all warrant holders. The question is how to separate those warrant holders who would be “affected” by a proposed amendment and those who would not. Black’s Law Dictionary (8th edition) defines “affect” as “[m]ost generally to produce an effect on; to influence in some way.”

BPW launched its consent solicitation, seeking approval of the warrant holders to amend the Warrant Agreement, after Talbots commenced its exchange offer (on March 1): How would the warrants of warrant holders who had tendered their warrants to Talbots be “affected” by any amendment of the Warrant Agreement? As warrant holders, tendering warrant holders no longer had any interest in the old warrants, so arguably they could not be “affected” by any amendment of the Warrant Agreement (the consent solicitation was conditional upon occurrence of the merger, so no amendments would be made to the Warrant Agreement if the Talbots/BPW deal fell apart.)

Should the word “adversely” be read into “affected” by the amendment? Assume only two warrant holders, one whose surname begins with the letter “A” and a second whose surname begins with the letter “B.” Assume A owns a majority of the outstanding warrants. What an amendment that deferred the exercise period of the warrants of all warrant holders whose surname begins with a “B” by one year (but adding a year of exercise to the back-end of the warrant exercise period) be valid if approved by “A”?

It strikes this observer that a good argument can be made, based solely on the text of the BPW Warrant Agreement requiring approval for amendments from a majority in interest of those warrant holders “affected” by the amendment, that the BPW warrant holders who tendered into the Talbots exchange offer were not within that class of warrant holders “affected” by the proposed amendments and that therefore the proposed amendments to the BPW Warrant Agreement should only have been decided by the warrant holders who elected not to tender, since they were the only warrant holders, qua warrant holders, who would be affected by the proposed amendments.

Vice Chancellor Strine himself, during the hearing on March 26th on Pentwater’s application for a TRO, highlighted this very issue, although not in the context of an argument that this observer makes here (since Pentwater did not make the argument):

“. . . I guess what they’re saying [Pentwater’s counsel] is, that people are voting [on the amendments to the Warrant Agreement] without any interest in being subject themselves to the contractual change that they’re making.”

Transcript at 60:5-8.

Pentwater did not make the “affected” argument, perhaps because it would not have supported a TRO, but, to this observer, the argument is a good one, and, if made, would have focused the court’s attention on the fact that, by the very provisions of Section 18 of the Warrant Agreement, governing amendments, not all BPW warrant holders are to vote on all proposed amendments to the Warrant Agreement.

But there is more. Section 18 of the BPW Warrant Agreement prohibits any amendment without the consent of the “affected” warrant holders that would, among other things, “reduce” the warrant exercise period or “reduce” the number of BPW common shares issuable upon exercise of a warrant.

Under the Warrant Agreement, the exercise period of the BPW warrants was to commence upon the consummation of any deal and terminate on the earlier of February 26, 2014 or any earlier redemption of the warrants. (The BPW warrants were redeemable at $0.01 per warrant (thus forcing exercise of the warrants) when the share price of BPW’s common equaled or exceeded $13.25 per share for 20 trading days.)

BPW proposed, by its amendments to the Warrant Agreement, to delay the warrant exercise period for 12 months and to add a year to the back-end of the warrant exercise period, thus preserving the length of the warrant exercise period. So, naturally, it argued before Vice Chancellor Strine that there had been no “reduction” in the length of the warrant exercise period, citing the definition of “reduce” in Merriam Webster’s Collegiate Dictionary, as meaning “to diminish in size, amount, extent, or number.” Opposition Brief at 14.

Pentwater responded by arguing that “to remove a particular year from a defined term of years is to ‘reduce’ or ‘diminish’ that term of years by one year.” Pentwater’s Reply Brief at 3. Moreover, as Pentwater noted, BPW’s position would lead to the absurd conclusion that it could have proposed amending the warrant exercise period to delay its commencement for several decades and not, under this interpretation of reduction, run afoul of Section 18 of the Warrant Agreement.

Neither BPW’s counsel nor Vice Chancellor Strine addressed this “reductio ad absurdum” claim, but it should have been addressed. An interpretation of “reduce” in Section 18 of the Warrant Agreement is not tenable if it does not foreclose the possibility that a delay in the warrant exercise period for years (as long as coupled with an extension of the back-end of the warrant exercise period by a like amount) would be permitted by Section 18. The only way to eliminate this absurd possibility is to define reduce by reference to the back-end of the warrant exercise period, namely, that “reduce” should refer to any shortening of the termination date to a date earlier than February 26, 2014.

One reply might be that the condition that amendments be approved by a majority in interest of the warrant holders is sufficient protection against amendments that would lead to an absurd result such as that posited by Pentwater, e.g., a delay in the warrant exercise period for decades. But then that confronts the provision of Section 18 of the Warrant Agreement that stipulates that only “affected” warrant holders are to vote on proposed amendments — a “majority” of the warrant holders who are not affected by a proposed amendment should not be permitted to vote on the amendment. In the above example of “A” and “B,” just as “A” should not be allowed to vote on an amendment that would further its interest at the expense of “B,” so those warrant holders who tendered into the Talbots exchange offer should not have been permitted to vote on an amendment that would have absolutely no effect on them, as warrant holders.

Similarly, it strikes this observer that Pentwater had the better argument that Section 18’s prohibition on amendments that would reduce the number of shares issuable upon exercise of the BPW warrants prohibited BPW’s proposed elimination of the anti-dilution protections of Section 11 of the Warrant Agreement. BPW argued that any amendments to Section 11 were not within the scope of Section 18’s protective provisions: “Nothing in section 18 of the Warrant Agreement prevents modification of the anti-dilution provisions in section 11.” Opposition at 15.

That may be true, but it should be irrelevant. Any amendment that would reduce the number of shares issuable upon exercise of the BPW warrants should fall within the scope of the protective provisions of Section 18 whether by amendment to Section 11 of the Warrant Agreement or to any other provision of the Warrant Agreement. BPW made clear in its consent solicitation that the effect of removing anti-dilution protection from the BPW Warrant Agreement would be to permit, among other things, stock splits of the common stock of Talbots (into which warrants not tendered to Talbots would be exercisable after the completion of the merger) with “no corresponding increase to the number of shares . . . issuable on exercise of unexchanged BPW Warrants . . .” Consent Solicitation Statement, dated March 16, 2010, Barancik’s cover letter, page 1.

E. BPW’s Alleged Violation of the Covenant of Good Faith and Fair Dealing

Pentwater asserted in its complaint that the proposed amendments to the Warrant Agreement not only breached its explicit terms but also BPW’s implied covenant of good faith and fair dealing, inherent in all contracts. By proposing to reduce the warrant exercise period and the number of shares issuable upon exercise of the warrants, without the consent of all “affected” warrant holders, BPW would be frustrating the “reasonable commercial expectations” of the warrant holders and the intended purpose of the Warrant Agreement. In support of its assertion, Pentwater pointed to, among other provisions, Section 11(g) of the Warrant Agreement. This provision, the last subsection of Section 11 of the Warrant Agreement addressing the circumstances in which adjustments to the terms of the warrants were to be adjusted to protect the warrant holders, states:

“(g) Other Events. If any event occurs as to which the foregoing provisions of this Section 11 are not strictly applicable or, if strictly applicable, would not, in the good faith judgment of the Board, fairly and adequately protect the purchase rights of the registered holders of the Warrants in accordance with the essential intent and principles of such provisions, then the Board shall make such adjustments in the application of such provisions, in accordance with such essential intent and principles, as shall be reasonably necessary, in the good faith opinion of the Board, to protect such purchase rights as aforesaid and shall give written notice to the Warrant Agent [Mellon Investor Services LLC] with respect to such determinations.”

(Emphasis added.)

Talbots and BPW, in their opposition to Pentwater’s application for a TRO, mocked Pentwater’s covenant claims as the “last refuge of the contractually unprotected,” Opposition at 5, asserting that, since Pentwater’s claims did not fit within the “narrow language” of Section 18 requiring individual warrant holder consent for amendments to the Agreement, Pentwater was seeking to “re-write” the Warrant Agreement. Opposition at 16-17.

The Warrant Agreement is governed by New York law, and BPW heavily relied upon the New York Court of Appeals’ (New York’s highest court) decision in Reiss v. Financial Performance Corp., 97 N.Y.2d 195, 64 N.E.2d 958 (2001) in support of its position. Reiss involved an objection by an issuer to the attempted exercise of warrants following the issuer’s one-for-five reverse stock split. Unfortunately for the issuer, the warrant agreement did not provide for any adjustment in the number of shares issuable upon exercise of the warrants upon a reverse (or forward) stock split; the reverse stock split therefore made the warrants more valuable. Making matters more difficult for the issuer, it had, before entering into the warrant agreement in question, issued a warrant with provisions addressing stock splits.

The New York Court of Appeals essentially concluded that the issuer had made its bed and now must lie in it. An omission or mistake, observed the Court, “does not constitute an ambiguity,” and courts may not, by construction, “add or excise terms,” or “make a new contract for the parties under the guise of interpreting the writing . . . .” 97 N.Y.2d at 199.

But Reiss is not the solid foundation BPW cites it to be. Somewhat surprisingly, the New York Court of Appeals observed, at the end of its decision, that, had the tables been reversed, and the warrant holder were before the court objecting to a forward stock split, the warrant holder might be entitled to a remedy “if Financial [the issuer] performed a forward stock split, on the theory that he [the warrant holder] ‘did not intend to acquire nothing.’” Reiss, 97 N.Y.2d at 201. “We should not assume,” observed the Court, “that one party intended to be placed at the mercy of the other . . . .” Id.

Delaware most recently articulated the content of the implied covenant of good faith and fair dealing in the Supreme Court’s April 6, 2010 decision in Nemec v. Shrader, 2010 WL 1320918, a 3-2 decision affirming Chancellor Chandler’s rejection of a covenant claim brought by two former stockholders of Booz Allen. As explained by the majority of the Supreme Court:

“The implied covenant of good faith and fair dealing involves a ‘cautious enterprise,’ inferring contractual terms to handle developments or contractual gaps that the asserting party pleads neither party anticipated. ‘[O]ne generally cannot base a claim for breach of the implied covenant on conduct authorized by the agreement.’ We will only imply contract terms when the party asserting the implied covenant proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected. When conducting this analysis, we must assess the parties’ reasonable expectations at the time of contracting and not rewrite the contract to appease a party who later wishes to rewrite a contract he now believes to have been a bad deal. Parties have a right to enter into good and bad contracts, the law enforces both.”

Slip Opinion at 10 (footnotes and citation omitted).

The best guidance on Pentwater’s covenant claim is that provided by one of the most celebrated jurists who have sat on the Delaware Chancery Court, Chancellor Allen, in his decision in Katz v. Oak Industries Inc., 508 A.2d 873 (Del. Ch. 1986). The facts of Katz were similar to those challenged by Pentwater: Oak Industries, in financial distress, proposed an exchange offer to its debt holders offering to exchange outstanding debentures for newly-issued notes, stock and warrants. At the same time, Oak arranged the sale of one of its businesses to Allied Signal and an equity investment by Allied Signal, contingent upon successful completion of the exchange offer.

Those noteholders who wish to participate in the exchange offer were required, as a condition to the exchange, to consent to amendments to the underlying indentures that would remove many of Oak’s financial covenants. Katz, a holdout, objected to this feature of the exchange offer as coercive, a violation of the contractual provisions of the indentures, and a violation of the implied covenant of good faith and fair dealing.

In his analysis, Chancellor Allen viewed the dispute as one of contract, not as a question of fairness or breach of fiduciary duty: “The terms of the contractual relationship agreed to and not broad concepts such as fairness define the corporation’s obligations to its bondholders.” 508 A.2d at 879 (footnote omitted). (The same test applies to relations between an issuer and holders of its outstanding warrants and options.)

Moreover, that the Oak board proposed the exchange offer to benefit Oak’s common stockholders at the possible expense of its bondholders “does not itself appear to allege a cognizable legal wrong.”

“It is the obligation of directors to attempt, within the law, to maximize the long-run interests of the corporation’s stockholders; that they may sometimes do so ‘at the expense’ of others . . . does not for that reason constitute a breach of duty.”

508 A.2d at 879.

In addressing Katz’s allegations of “coercion,” Chancellor Allen tied the concept to the specific allegations of breach of contract made by Katz and not to any stand alone concept of “coercion,” that is to say, the “relevant legal norm that will support the judgment whether such ‘coercion’ is wrongful or not will . . . be derived from the law of contacts.” Id. at 880.

Chancellor Allen viewed the implied covenant as follows:

“Modern contract law has generally recognized an implied covenant to the effect that each party to a contract will act with good faith towards the other with respect to the subject matter of the contract.”

For him, the appropriate legal test was the following:

“ . . . is it clear from what was expressly agreed upon that the parties who negotiated the express terms of the contract would have agreed to proscribe the act later complained of as a breach of the implied covenant of good faith — had they thought to negotiate with respect to the matter. If the answer to this question is yes, then, in my opinion, a court is justified in concluding that such act constitutes a breach of the implied covenant of good faith.”
508 A.2d at 880.

If this is the test, it is hard to see how it would not apply to a claim by a BPW warrant holder who did not participate in the Talbots exchange offer that delaying by one year the commencement of his or her warrant exercise period or eliminating the anti-dilution protections of the BPW Warrant Agreement, without that warrant holder’s consent, is not a breach of the covenant. The whole purpose of the BPW warrants, which were designed to trade separately from BPW’s common stock, was to grant the warrant holders an upside kicker once BPW did a deal. To delay the exercise period for one year is fundamentally at odds with the investment appeal of the warrants in the first place. It is hardly conceivable that any rational warrant holder would have agreed to such provision back in February 2008 when the warrants were issued. The same argument holds true for the amendment eliminating anti-dilution protections.

F. The Stronger Case

Pentwater’s challenge to BPW’s consent solicitation was weighted with too much baggage to succeed. In seeking a TRO enjoining not only the consent solicitation but Talbots’ exchange offer, Pentwater sought to hold up a merger that had been approved by the shareholders of both Talbots and BPW. Had Pentwater had the courage of its convictions (and a lot of money to spend on litigation), it would have voted against the consent solicitation, awaited the merger’s close, and then sued for contractual damages. Since Pentwater, like all hedge funds, is in the business of making money and not litigating, it would be entirely understandable if, having suffered defeat at the hands of Vice Chancellor Strine, it tendered into Talbots’ exchange offer and moved on.

But not all warrant holders did so. That may well be explained by inertia, uninformed warrant holders, etc. But any warrant holder who might challenge the amendments approved by (a bare majority) of the warrant holders would have a stronger case than Pentwater, since that case would focus solely on the contractual provisions of the Warrant Agreement and the covenant of good faith and fair dealing.

Otherwise, the lessons for hedge funds and arbitrageurs seeking to exploit opportunities involving warrants is clear: buyer beware.

Selectica, Inc. v. Versata Enterprises, Inc.: The Court's Treatment of Director Independence & the Preclusivity of Defensive Measures

2010-03-10T16:27:00.000-08:00

In my post of March 4 I noted that Vice Chancellor Noble addressed certain important doctrinal issues that I passed on to address how Trilogy’s negotiating posture with Selectica heavily influenced the Vice Chancellor’s decision to affirm the Selectica board’s adoption and triggering of a NOL pill. In this post I address two of those other issues addressed by Vice Chancellor Noble.

A. “Inside” Directors Treated as Independent

The Vice Chancellor had to review the Selectica board’s actions in light of the Unocal standard that applies enhanced scrutiny to a defensive measure adopted to thwart or impede a takeover to ensure that the action is motivated by a good faith concern for the welfare of the corporation and its stockholders and to ensure that the board did not act solely or primarily out of the desire to perpetuate themselves in office. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985). A board must also demonstrate that its defensive response was reasonable in relation to the threat posed. As clarified by the Court in Unitrin, a defensive measure is disproportionate, or unreasonable, if it is either “coercive” or “preclusive.” Unitrin, Inc. v. American General Corp., 651 A.2d 1361, 1387 (Del. 1995).

A board’s conduct is viewed more favorably by the Delaware courts if the defensive actions are taken by a majority of independent directors. So the initial fight before Vice Chancellor Noble between Selectica and Trilogy was over the independence of the four directors sitting on the Selectica board that adopted and triggered the NOL poison pill. The Vice Chancellor’s treatment of two of them attracted my attention. Directors Zawatski and Thanos both were appointed Co-Chairs of the board in August 2008 after the board terminated the CEO and elected not to replace him. (After August 19, 2009, Zawatski became the sole Chair of the board and “continued to handle the Company’s daily operations.” Slip Opinion at 5, note 10.)

Delaware law distinguishes between an “outside” director and an “independent” director. An outside director is a non-employee and a non-management director who receives no income other than usual directors’ fees. Slip Opinion at 35. Delaware applies a subjective person standard, however, in considering the question of director independence, examining the relevant facts to determine whether the director is one whose decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences, and whether the director is dominated or otherwise controlled by an individual or entity interested in the transaction.

There is little question that Zawatski and Thanos did not qualify as “outside” directors under either Delaware law or the applicable standards of the SEC and the stock exchanges. As Co-Chairs of the board, they performed duties comparable to those of the CEO, a disqualification by itself under the independence standards of the SEC and the exchanges. Moreover, while each claimed their compensation was not material to them, as Co-Chairs Thanos was paid $164,125 and Zawatski $274,273 in addition to their compensation as directors, another basis for disqualifying them as independent under SEC and stock exchange standards.

Nevertheless, Vice Chancellor Noble concluded that each, based on the record before him, were independent. As he noted:

“Both Thanos and Zawatski were retired and took on the Co-Chair position following successful careers in the private sector. Both serve on multiple boards and both have testified that the income they receive in these roles is not personally material to them, and that they hope to be able to resign these positions in the near term.”

Slip Opinion at 39 (footnote omitted).

While the Vice Chancellor could not conclude that Selectica’s board’s actions in adopting and triggering the NOL poison pill against Trilogy were entitled to “material enhancement” by reason of the independence of the board, in effect he granted the board that presumption, clearly influenced by their conduct in the situation the board found itself following the CEO’s termination. He rejected as groundless the concern that the board’s actions stemmed from a desire for entrenchment. As he noted:

“Both Zawatski and Thanos had previously been outside directors before taking over management duties and had only temporarily assumed these duties in lieu of hiring a new CEO in anticipation of the Company’s proximate sale. Further, one may readily presume that, given the financial plight of the Company, attracting additional independent and qualified directors might be difficult.”

Id. at 40.

B. Did Selectica’s Five Percent Trigger Make Its NOL Pill Preclusive?

The second topic of interest in Vice Chancellor Noble’s application of Unocal to Selectica’s board’s adoption and triggering of its NOL pill is his treatment of Trilogy’s claim that adoption of the pill was unreasonable because it was “preclusive.” A defensive measure is preclusive under Delaware law where it operates to unreasonably preclude a takeover or precludes effective stockholder action, including where a measure makes a bidder’s ability to wage a successful proxy contest and gain control either mathematically impossible or realistically unattainable. Slip Opinion at 54.

The Vice Chancellor’s treatment of Trilogy’s claim of preclusion makes clear that defensive measures must be extreme before they will be invalidated by the Delaware courts. Defensive measures that make it more difficult for an acquirer to obtain control of a board are not preclusive; preclusive measures are those that are “insurmountable” or “impossible to outflank.” Id. at 55, citing tionIn re Gaylord Container Corporation Shareholders Litigation, 753 A.2d 462, 481-482 (Del. Ch. 2000). Trilogy’s primary claim of preclusivity focused on the NOL trigger — 4.99% of Selectica’s outstanding common shares. Trilogy argued that this low trigger “renders the possibility of an effective proxy contest realistically unattainable.” Slip Opinion at 56. With such a low trigger, argued Trilogy, a challenger could not establish a sufficient foothold in the securities of the target to establish a credible threat to incumbent management. Moreover, the low trigger combined with a staggered board (such as characterized the Selectica board), further rendered a potential takeover unrealistic since a proxy contest would have to be sustained over multiple years to gain control of the board.

Selectica effectively countered by pointing to the adoption by more than 50 publicly-held companies of NOL pills with triggers of roughly 5%, and to some 15 proxy contests occurring over a three-year period where the challenger controlled less than 5.49% of the outstanding shares, with the challenger successfully obtaining board seats in ten of such contests, including five involving companies with classified boards.

Vice Chancellor Noble granted Trilogy the point that the low trigger of a NOL poison pill “has a substantial preclusive effect,” Slip Opinion at 59, but concluded that the effects were not “draconian,” and therefore not preclusive under the Unocal/Unitrin standards:

“It is not enough that a defensive measure would make proxy contests more difficult — even considerably more difficult. To find a measure preclusive (and avoid the reasonableness inquiry altogether), the measure must render a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand.”

Slip Opinion at 60 (footnote omitted).

What are examples of preclusive defensive measures? Vice Chancellor Noble cites two examples, those condemned by the Delaware Supreme Court in Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003) — a no-shop, submit the agreement to the stockholders even if the board changes its recommendation, and shareholder lock-ups of more than 50% of the outstanding shares — and that condemned by Vice Chancellor Jacobs in Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch. 1998) where the Vice Chancellor found the adoption of a “dead-hand” poison pill preclusive (the pill in Carmody could only be redeemed by the directors who adopted it or their designated successors).

The question that naturally arises from Vice Chancellor Noble’s conclusion on preclusion is whether a creative board could justify a 5% or so trigger for reasons other than preserving NOLs. If it can, then Selectica is authority for the proposition that a low-trigger pill, even when adopted by a board with staggered terms, will not be considered preclusive under Delaware law.

Selectica, Inc. v. Versata Enterprises, Inc.: Delaware Chancery Court Upholds Trigger of Poison Pill

2010-03-04T11:39:00.000-08:00

This case has already gotten lots of attention, as the first instance of the triggering of a poison pill. In his decision of February 26, 2010, 2010 WL 703062, Vice Chancellor Noble concluded that Selectica’s board acted reasonably in adopting a low-threshold (4.99%) poison pill to protect the company’s NOL. His careful decision illustrates why participants in contests for control should always ask themselves “how will this look before the Delaware Chancery Court?”

A. Bad Blood Between Selectica and Trilogy, Inc.

Both Selectica and Trilogy, Inc. provide enterprise software solutions for contract management and sales configuration systems, whatever that means. Trilogy, a private company, is controlled by Joseph Liemandt, its founder and over 85% stockholder. Trilogy had been successful in two patent infringement lawsuits against Selectica, securing a judgment in one of $7.5 million and a settlement in the other of up to $17.5 million, of which some $7.5 million was deferred. Trilogy had also made several unsuccessful runs at acquiring Selectica, which Selectica’s board rebuffed. By the end of 2006, Trilogy had disposed of its Selectica shares.

B. Selectica’s NOL

Since Selectica went public in March 2000, it had never turned a profit. By the time of the dispute before Vice Chancellor Noble in the spring of 2009, it was trading below $1 per share, and it had incurred operating losses of some $160 million. Fewer than 25 investors held some two-thirds of its outstanding stock.

Selectica’s NOL drew the attention of Steel Partners, a private equity fund specializing in smaller cap companies. Steel Partners saw an opportunity in marrying Selectica with a profitable company to exploit Selectica’s NOL. As a result of pressure from Steel Partners, Selectica retained specialists to analyze its NOL and the complicated provisions governing the loss of NOLs if a company undergoes an “ownership change” as defined in IRC Code §382, generally defined as an ownership change of more than 50 percentage points by one or more 5% shareholders within a period of three years. If such an ownership change occurs, then a substantial portion of the NOL is lost.

C. Exploration of Strategic Alternatives

By July of 2008 Selectica concluded it had to explore strategic alternatives. It retained Needham & Company to evaluate its alternatives. The evaluation included reaching out to potential buyers. By February 2009, at least half a dozen parties were seriously interested in Selectica. By April 2009, Selectica had signed a letter of intent and entered into exclusive negotiations with a potential buyer.

D. Trilogy Butts In

Trilogy resumed its interest in Selectica in the summer of 2008. Trilogy made a couple of lowball offers for Selectica, which were rejected by its board. It was invited to engage in the sale process being overseen by Needham, but it declined, apparently out of unwillingness to sign a non-disclosure agreement. Trilogy and its founder, Liemandt, commenced buying Selectica’s stock in the open market. The buying crossed the 5% threshold in November 2008, prompting Trilogy to file a Schedule 13D, in which it stated that it had acquired the Selectica shares “for investment purposes.”

E. Selectica’s Adoption of the NOL Pill

The Selectica board, concerned about the effect of Trilogy’s purchases on its NOL, arguably Selectica’s major asset, engaged its accounting and tax advisors to evaluate its NOL and its potential loss through an “ownership change.” They concluded, after extensive analysis and consultation with the board, that the NOL was valuable and that Trilogy’s actions in acquiring Selectica shares threatened it. On November 16, 2008, the board amended its previous shareholder rights plan, adopted in February 2003, with a view to protecting its NOL. The trigger was dropped from 15% to 4.99%, with existing 5% stockholders grandfathered to permit them to acquire up to an additional 0.5% of Selectica’s shares (subject to the original 15% cap) without triggering the pill. The board established a committee of independent directors to periodically review the pill to determine whether it would continue to be in the best interest of Selectica and its stockholders.

F. Trilogy Buys Through the Trigger

Adoption of the NOL poison pill apparently outraged Trilogy and its controlling stockholder, Liemandt. Liemandt promptly inquired of two of Trilogy’s officers how many shares of Selectica Trilogy and Liemandt would need to purchase “to ruin the tax attributes” of the NOL. Slip Opinion at 20. Trilogy then promptly notified Selectica that a contract it had known about for some four months between Selectica and Sun Microsystems breached the terms of the prior patent infringement settlement between Selectica and Trilogy.

By December 19, 2008, Trilogy had blown through the NOL trigger, attaining 6.7% ownership of Selectica’s outstanding common stock. Selectica then had 10 days, under the terms of the plan, to determine whether Trilogy would qualify as an “exempt person” under the plan, thus avoiding triggering the pill. What was Liemandt’s motive in blowing through the trigger?

“Liemandt testified that the rationale behind triggering the pill was to ‘bring accountability’ to the Board and ‘expose’ what Liemandt characterized as ‘illegal behavior’ by the Board in adopting a pill with such a low trigger.”

Slip Opinion at 21 (footnote omitted).

And what was Trilogy’s proposal to Selectica?

“He [an officer of Trilogy] then proposed that Selectica agree to purchase Trilogy’s shares back, accelerate the payment of its [$7 million] debt, terminate its license with Sun, and make a payment to Trilogy of $5 million ‘for settlement of basically all outstanding issues between our companies.’”

Slip Opinion at 22 (footnote omitted).

This is what one might term an “unvarnished” proposal. One suspects it was not vetted with experienced counsel.

Needless to say, the Selectica board rejected Trilogy’s settlement demands as “highly unreasonable” and “lacking any reasonable basis in fact.” No kidding.

G. After Trilogy Repeatedly Rejects Requests for a Standstill, Selectica Triggers the Pill

Selectica repeatedly requested that Trilogy agree to a standstill and not purchase any additional shares of Selectica stock. Trilogy rejected the demands. Accordingly, after extensive consultation with its tax and legal advisors, the board, on January 2, 2009, implemented the pill and authorized an exchange of rights of common stock and a reloading of the pill. As a result of the exchange, the number of outstanding shares of Selectica’s common stock was doubled, other than for Trilogy and its affiliates, whose ownership of Selectica stock dropped from 6.7% to 3.3%.

H. The Court’s View of Trilogy’s Conduct

Vice Chancellor Noble’s discussion of poison pills, Selectica’s NOL poison pill, and the standards governing the adoption and exercise of a poison pill are important and deserve attention, but not in this post. What I want to focus on is how Trilogy’s ill-advised and, frankly, off the wall conduct in negotiations (or the lack thereof) with Selectica influenced the Vice Chancellor.

At trial and in post-trial argument, Trilogy and its counsel mounted an impressive challenge to all aspects of Selectica’s board’s conduct, including the justification for any NOL pill, the processes followed by the Selectica board in adopting and implementing the pill, the board’s reliance upon experts, and the failure of the Selectica board to meet the Unocal tests for application of the business judgment rule to the adoption of a defensive measure such as a poison pill. All of these objections were carefully rejected by Vice Chancellor Noble. Trilogy’s arguments have a distinct ex post flavor. One cannot escape the conclusion that this case was decided by Trilogy’s opportunistic behavior in making a run at Selectica to coerce it into meeting demands of Trilogy that had nothing to do with Selectica’s governance or its control. As the Vice Chancellor notes at the end of his extensive opinion:

“Here, the record demonstrates that a longtime competitor sought to employ the shareholder franchise intentionally to impair corporate assets [of Selectica], or else to coerce the Company into meeting certain business demands under the threat of such impairment.”

. . . .

In this instance, Trilogy, a competitor with a contentious history, recognized that harm would befall its rival if it purchased sufficient shares of Selectica stock, and Trilogy proceeded to act accordingly.”

Slip Opinion at 65, 69.
______________________

Kudos to the Selectica directors. They served on the board of a small company that had never made money and had been pushed around by an aggressive competitor. They did something no other board had ever done, trigger a poison pill. In a risk averse world, that took courage. Their judgment and determination have been rewarded by Vice Chancellor Noble’s decision in this case.

SEC v. Bank of America Corp.: Judge Rakoff Approves the Second Settlement, Damming It With No Praise

2010-02-22T18:12:00.001-08:00

Judge Rakoff held his nose today and approved the second settlement submitted to him by the SEC and BofA. Channeling popular rage over Wall Street, bank bailouts, and excessive executive compensation, the Judge, deferring to the SEC’s judgment that the settlement is fair, reasonable, adequate, and in the public interest, and exercising judicial restraint, approves the settlement while “praising” it as “better than nothing,” and representing “half-baked justice at best.” Opinion and Order of February 22, 2009 (“Opinion”) at 14.

A. Not One for Framing

In light of Judge Rakoff’s treatment of their settlement of this case, it is unlikely that the Commission or its enforcement staff will highlight SEC v. Bank of America Corp. in their accomplishments for 2010. Judge Rakoff is not hesitant to express his views of the Commission’s work product. He announces at the beginning of his opinion that he “reluctantly” grants the Commission’s motion to approve the settlement. He makes clear up front that, based upon his review of the evidence developed by the Commission since his rejection of the first settlement presented to him in the summer of 2009, that BofA’s proxy statement sent to its shareholders in connection with the December 5, 2008 meeting called to approve the Merrill merger failed to adequately disclose the Bank’s agreement to pay Merrill executives up to $5.8 billion in bonuses and failed to adequately disclose the huge losses Merrill suffered during the fourth quarter of 2008. He belittles the Bank’s defense that the nondisclosures were not material:

“Despite the Bank’s somewhat coy refusal to concede the materiality of these nondisclosures, it seems obvious that a prudent bank shareholder, if informed of the aforementioned facts, would have thought twice about approving the merger or might have sought its renegotiation.”

Opinion at 3-4.

As I have noted in previous posts, the Judge was clearly influenced by the allegations of New York’s Attorney General, Andrew Cuomo, in his action against the Bank, Lewis, and Price, filed the day before the Commission presented its second settlement for Judge Rakoff’s approval. The Judge sought and received transcripts of Cuomo’s office’s examination of BofA General Counsel Mayopoulos and others, receiving it ex parte due to that office’s objection to making public the transcripts of such testimony (on the grounds that it would prejudice the office’s prosecution of the case against the Bank and its two former principal officers were the transcripts shared with the Bank).

The Judge rejects the Bank’s objection to his consideration of evidence from Cuomo’s case as “frivolous,” asserting that it would have been a “dereliction” of his duty to ignore evidence of Cuomo’s claims of willful misconduct to test the factual assumptions underlying the settlement presented by the Commission to him for approval. On the other hand, the Judge concedes, in a footnote, that his decision to accept the materials “ex parte” was “problematic,” acknowledging the Bank’s “legitimate concern that the Court’s determinations be made on a record fully available for [its] scrutiny.” Opinion at 6, note 3.

B. Mayopoulos’ Firing

After reviewing the evidence submitted to him, the Judge “concludes that none of the evidence directly contradicts the Bank’s assertion that Mayopoulos’ termination was unrelated to the nondisclosures or to his increasing knowledge of Merrill’s losses.” Opinion at 7. Nevertheless, the Judge is careful to note that “contrary inferences might be drawn” from the evidence, including the fact that the Bank terminated Mayopoulos on such short notice and “asked [him] to leave the premises immediately.” Id.

C. Officers of BofA Acted Negligently

Perhaps the most crucial conclusion reached by the Judge is that the evidence supports the Commission’s conclusion “that the Bank and its officers acted negligently, rather than intentionally, in causing the nondisclosures that are the predicates to the settlement here proffered, …” Id. at 8. This conclusion was “reasonable” by the SEC, supported by “substantial evidence,” and one that a “reasonable regulator could draw.” Id. It is highly unlikely the Bank will cite any language from this Opinion, but if it does it will be this text.

D. The Settlement’s Prophylactic Measures

The Judge accepts the prophylactic measures exacted from the Bank by the SEC, including the modifications to two of them that he requested, and accepts the Bank’s rejection of the suggestion that the SEC and the Court play a role in the selection of an independent compensation consultant to the Board’s compensation committee. In doing so, the Judge cannot help getting in his digs on the Bank’s officers and lawyers:

“Given that the apparent working assumption of the Bank’s decision-makers and lawyers involved in the underlying events at issue here was not to disclose information if a rationale could be found for not doing so, the proposed remedial steps should help foster a healthier attitude of ‘when in doubt, disclose.’”

Opinion at 9.

E. The Settlement’s $150 Million Fine

The Judge’s strongest criticism is for the $150 million fine agreed to by the Bank in the second settlement. Accepting the Bank’s and the Commission’s agreement to explicitly provide that distribution of the fine will not be made to Merrill “legacy” shareholders of BofA or to Bank officers or directors who had access to the undisclosed information, Judge Rakoff continues to express his outrage that innocent shareholders, including innocent Merrill legacy shareholders of BofA, are bearing the cost of the fine and not the culpable officers of Bank, even if they were guilty only of negligence:

“… the effect [of the exclusion of Merrill legacy shareholders] is very modest, amounting perhaps to no more than a few pennies per share. Moreover, while the ‘legacy’ Merrill shareholders may have received something of a windfall as a result of the nondisclosures, they were not responsible for those nondisclosures. Rather, the responsibility was that of the Bank’s executives, who, although barred from receiving any part of the $150 million fine, are not contributing to its payment in any material respect.”

Opinion at 13.

So, all in all, while the settlement, concludes Judge Rakoff, is “better than nothing, this is half-baked justice at best.” Opinion at 14.

In fact, the Judge goes as far as to state that if this proposed settlement were first presented to him, he would reject it as “inadequate and misguided.” Id. So why is he approving it? Because, explains the Judge, he would “fail in [his] duty if [he] did not give considerable weight to the S.E.C.’s position.” And, even more importantly to the Judge, he has to take into account “considerations of judicial restraint,” meaning that, having made his preferences clear, he cannot act upon them!

So, realizing that he is a judge and not an enforcement god, Judge Rakoff “while shaking [his] head,” approves the settlement.

It is safe to say that the Bank and the Commission are more than pleased to close the door on Judge Rakoff’s courtroom and exit Foley Square as quickly as possible.

SEC v. Bank of America Corp.: Ruling on Second Settlement Imminent; Judge Rakoff: Bull in a China Shop

2010-02-20T17:27:00.000-08:00

Judge Rakoff is scheduled to rule on the second settlement submitted by the SEC and BofA for Court approval this coming Monday, February 22. It is apparent from the submissions made by the parties since my post of February 12 that both the SEC and the Bank are saying to the Judge “Enough, Already,” and want him to get on with it and approve the settlement. I still believe he will do so, but lifetime tenure does something for federal judges – it makes them very, very independent.

A. The SEC’s Supplemental Statement of Facts

In response to the Judge’s February 11 order, both the SEC and the Bank have, through counsel, corresponded with Judge Rakoff, jointly submitted the evidentiary record on issues requested by the Judge, and the SEC has submitted a Supplemental Statement of Facts (the “Statement”) summarizing the evidentiary record. By the Statement, the SEC confirms its conclusions that:

• General Counsel Timothy Mayopoulos advised management of the Bank, after conferring with the Wachtell firm, that the Bank was not required to make additional disclosure to its shareholders concerning Merrill’s forecasted fourth-quarter losses before the shareholder meeting held on December 5, 2008;

• Wachtell supported Mayopoulos’s advice; and

• Mayopoulos’s firing on December 10, 2008 was “for reasons which had no connection to his legal advice or any other aspect of his job performance.” Statement ¶2.

The Commission does not provide any argument in the Statement. By its detail, however, the Commission reinforces its conclusion that there is no basis for a finding of bad faith or scienter by Mayopoulos or Wachtell in the legal advice they gave the Bank.

While the evidence cited by the Commission on Mayopoulos’s firing supports the Commission’s conclusion on the absence of any motive to terminate Mayopoulos for any legal advice he gave, the termination does illustrate the brutality of corporate politics. According to the evidence developed by the Commission, Mayopoulos was fired to make room for Brian Moynihan, then BofA’s head of its investment banking division (and now CEO of the Bank).

As a result of the pending merger with Merrill, Moynihan’s position was going to be eliminated, and John Thain, Merrill’s CEO, was to take over the combined entity’s investment banking operations. The BofA board of directors balked at Moynihan’s pending departure, urging Ken Lewis to find a suitable position for him. Lewis decided to place Moynihan in Mayopoulos’s position as General Counsel of the Bank, even though Moynihan had not practiced for years and his bar membership was not then even active.

So, according to the evidence developed by the SEC, Mayopoulos was fired not by reason of his performance, loyalty, or competence, but simply to make room for an officer that Lewis was prepared to lose but the Board of Directors of the Bank wanted to retain.

B. Cuomo’s Office’s Response

By its letter dated February 16, 2010 to the SEC, Cuomo’s office rejected the Commission’s request to turn over transcripts of the testimony of Mayopoulos and others given by them to Coumo’s office. Coumo's office stated that turning over such materials would adversely affect that office’s prosecution of its case against the Bank, Lewis, and Joe Price, the Bank’s former CFO.

In response to this letter, Judge Rakoff jumped in with his Order of February 17, stating his desire to see the requested materials to enable him to determine “whether the conclusions on which the S.E.C. premises its proposed settlement have an adequate basis in fact or are materially at variance with other sworn testimony.” Order at 2. Given the time constraints, the Judge simply requested that Cuomo’s office “voluntarily” produce the materials to the Court, suggesting that if Cuomo’s office deemed it necessary, the production could be made “ex parte,” meaning to the Court alone, without copying the SEC or BofA.

Cuomo’s office took up the suggestion and submitted the materials ex parte to the Court by its letter dated February 19.

C. BofA’s Response

BofA initially responded to Judge Rakoff’s Order of February 11 by its letter to the Court of February 16. Barely disguising its irritation, the Bank “respectfully” pointed out to Judge Rakoff that the second proposed settlement “was the result of arm’s length negotiations” between BofA and the Commission and, in the opinion of the Bank, “no changes” were necessary to the proposed consent judgment submitted by the Commission and the Bank to the Court. Nevertheless, the Bank stated its agreement to the Judge’s request for Commission and, possibly, Court involvement in the appointment of an independent auditor to assess the Bank’s disclosure controls and procedures and the retention of disclosure counsel for BofA’s audit committee.

But the Bank balked at Judge Rakoff’s request that the Commission and the Court participate in the selection of an independent compensation consultant for the Board’s compensation committee. The consent judgment submitted by the SEC and the Bank provides for the retention of an independent compensation consultant by the compensation committee, to be selected solely by the compensation committee. The Judge requested in his February 11 order that the consultant be acceptable to both the SEC and the Court and that, if the Bank and the SEC could not agree on the consultant, the Court would make that choice. That request irritated the Bank:

“. . . we do not believe that the third proposed change to the Consent Judgment is necessary to achieve or tailored to the remedial objectives of the settlement, and we further believe that this proposed change would impose on the SEC a substantive role that the SEC expressly does not seek and that is outside the province of the SEC and the Court.”

BofA letter of February 16, at 3 (footnote omitted).

In response to Cuomo’s office’s turning over materials, ex parte, to the Court, the Bank submitted its letter of February 18 in protest. The Bank’s position is that evidence developed in other forums and not in the pending actions against the Bank before Judge Rakoff should not be considered by the Court. This is not a frivolous complaint, and could serve as the basis for any appeal by the Bank to Judge Rakoff’s decision on the settlement, assuming he does not approve it.
____________________

If Judge Rakoff does not approve the second settlement, he will certainly confirm his reputation as a maverick. Without familiarity with the procedural hurdles that might confront the Commission or the Bank in challenging any rejection of the settlement by the Judge, one would think that if he rejects the settlement one or both of the parties will seek review of his decision by the Second Circuit and/or seek to disqualify Judge Rakoff from presiding over the trial of this case. It is not too much to ask how Judge Rakoff could maintain his impartiality if, as a result of his detailed review of deposition transcripts and other evidence, he concludes that the settlement should be rejected because the Commission has failed to name officers of the Bank and/or its counsel for securities law violations.

SEC v. Bank of America Corp.; The SEC and BofA Enter Into a Second Settlement; The Cuomo NY State Action

2010-02-12T14:10:00.000-08:00

The Commission and BofA are headed back to Judge Rakoff for approval of a second settlement after their first settlement was rejected by the Judge on September 14, 2009. From my initial reading of the terms of the settlement and the supporting papers filed by the SEC in support of the settlement, I concluded that it was highly likely the Judge would approve it on this second go-round. Then I read Attorney General Cuomo’s complaint of February 4, 2010 filed against BofA and its two principal officers, Ken Lewis (CEO) and Joe Price (CFO), in New York State Supreme Court (New York’s trial court) and I am not so sure. Cuomo’s complaint, which reads more like a brief for summary judgment than a complaint, contains extensive quotations and summaries of testimony and emails and gets the blood flowing. Judge Rakoff obviously has read it, because, as was apparent from the preliminary hearing he held on Monday, February 8, 2010, the Judge commented to counsel for the Commission and BofA that he found the $150 million civil penalty “still quite small,” questioned whether there should be court supervision of certain prophylactic aspects of the settlement, and questioned the Commission’s summary of evidence in support of the settlement in light of the even more extensive recitation of facts (albeit in the form of allegations) in Cuomo’s complaint. See New York Times, Tuesday, February 9, 2010, page B7, col. 2.

So while I still would hazard that Judge Rakoff is likely to approve the second settlement, the fireworks on this one are not over, and Cuomo’s allegations are often stunning and sure to prove discomforting to many of BofA’s senior officers and its counsel.

A. The Second Settlement

The civil penalty of $150 million agreed to by BofA in the second settlement is some five times the fine of $33 million in the August 2009 settlement rejected by the Judge. This is real money, particularly in light of the relevant statutory standards I addressed in my post of September 25, 2009, but a relative pittance compared to BofA’s historical earnings: for the five years ended December 31, 2008, BofA reported average annual net income, after taxes, of $14.1 billion, of which $150 million represents a scant 1.1%.

BofA also agrees to implement, for a period of three years, prophylactic measures designed to enhance its financial reporting and its compensation practices, and to grant shareholders a say in its compensation policies. These measures include auditor certification of the Bank’s disclosure controls and procedures in addition to the attestation now required by SOX § 404 for the Bank’s internal controls and procedures for financial reporting; CEO and CFO certifications of its proxy statements comparable to those now required of the Bank’s 10-Ks and 10-Qs; appointment of separate disclosure counsel for the audit committee of its board of directors; adoption of independence requirements for the members of its compensation committee comparable to those that apply to its audit committee; retention of an independent compensation consultant to be engaged by and to report solely to the compensation committee; institution and implementation of formal written incentive compensation principles and processes, to be amended only after seeking a separate advisory shareholder vote; and provision of a separate advisory shareholder vote at each annual meeting involving the election of directors regarding the Bank’s compensation of its executives. These measures would push BofA to the forefront of “best practices” in its shareholder reporting and provide gainful, and the emphasis is on “gainful,” employment for scores of lawyers, accountants, and compensation consultants.

To address Judge Rakoff’s concern that the $33 million fine imposed by the August 2009 settlement would be borne by the “innocent” victims of BofA’s failure to disclose its agreement with Merrill in its merger proxy statement to allow Merrill to pay up to $5.8 billion in incentive bonuses to its employees for 2008, this second settlement provides for the distribution of the penalty “solely” to the “harmed” BofA shareholders. The fund is to be distributed pursuant to a plan to be subsequently proposed by the Commission and approved by the Court under the provisions of Section 308(a) of SOX. Presumably those shareholders “harmed” by the Bank’s disclosure failures will not include any Merrill shareholders who received BofA stock in the merger.

In support of the settlement, the Commission has filed a 35-page “Statement of Facts” detailing relevant facts established by the evidence obtained by the Commission in discovery after Judge Rakoff’s September 14, 2009 rejection of the first settlement. In a written consent filed with the supporting papers, the Bank “acknowledges that there is an evidentiary basis for the statements in the Statement of Facts ….” Consent of Bank of America Corporation, dated February 1, 2010, ¶ 14. The Bank has further agreed “not to take any action or to make or permit to be made any public statement denying, directly or indirectly, the statements in the Statement of Facts or any allegation in the complaints filed in the Actions or creating the impression that the statements in the Statement of Facts or the allegations in the complaints are without factual basis.” Id. The SEC’s Statement is meticulous in its citation to the sources for each of the statements of fact made. It is safe to say that the Statement reflects the input of BofA’s counsel, as it includes statements (often in footnotes) that this commentator considers reflective of BofA’s defenses.

1. No “Bad Boy” Taint

In the August 2009 settlement rejected by Judge Rakoff, the Bank agreed not only to the payment of a civil penalty in the amount of $33 million, but also to the inclusion in the final judgment of a permanent injunction enjoining the Bank from violating Section 14(a) of the Exchange Act and Rule 14a 9 promulgated by the SEC thereunder, the proxy statement anti-fraud prohibition.

Presumably in exchange for the prophylactic covenants the Bank has agreed to in this settlement, the Commission sets forth no such injunction in this second settlement. That omission is a significant victory for the Bank. Under the SEC’s rules, an “ineligible issuer” is not entitled to use certain procedures and forms that allow it to access the capital markets quickly and efficiently. An institution such as BofA uses these procedures and forms every day. An ineligible issuer includes any issuer that, within the past three years, has been the subject of any judicial or administrative decree or order arising out of a governmental action that, among other things, “[r]equires that the person cease and desist from violating the anti-fraud provisions of the federal securities laws ….” SEC Rule 405 (definition of “ineligible issuer”). The omission of any injunction in this second settlement prohibiting the Bank from violating the proxy statement anti-fraud provisions of the Exchange Act is a significant win for the Bank.

2. Why BofA Excluded Mention of its Agreement for the Payment of Merrill’s Q4 2008 Bonuses from its Proxy Statement

Several of my earlier posts focused on the likely explanation for BofA’s omission from its proxy statement of its agreement with Merrill (contained in a schedule to the merger agreement) that Merrill could pay up to $5.8 billion in year-end bonuses to Merrill’s officers and employees. The SEC’s Statement of Facts discloses that the language of the schedule, permitting the payment of up to $5.8 billion in discretionary year-end bonuses, continued to be negotiated “through October 21, 2008,” Statement ¶ 39, over a month after the merger was announced and the merger agreement filed with the SEC (the schedule is an attachment, albeit not publicly filed, to the merger agreement).

Why was the agreement set out in the schedule with respect to the payment of year-end bonuses not mentioned in the merger proxy statement? The Commission summarizes the deposition testimony of Jeannemarie O’Brien, the Wachtell partner who was responsible for the employee benefits provisions of the merger agreement and their disclosure in the proxy statement, who provided this answer:

“According to O’Brien, the provision in the Schedule did not have to be disclosed because, she believed, the [bonus] awards that Merrill was authorized to pay under Section 5.2 to the Schedule were not special transactional bonuses and were regular year-end bonuses consistent with the prior year.”

Statement ¶ 40.

This explanation doesn’t make sense in the context of the actual language of the forbearance provision of the merger contract, which provided that Merrill would not, without the prior written consent of the Bank, “pay any amount to [directors, officers or employees] not required by any current plan or agreement (other than base salary in the ordinary course of business).” Merger Agreement § 5.2(c). Nevertheless, what the Commission obviously found persuasive is the uniform testimony of the Bank’s executives “that they generally relied on Wachtell Lipton for the accuracy, completeness, and legal compliance of the Bank’s proxy disclosures.” Statement ¶ 40.

The Commission’s Statement concludes in rather stark fashion, highlighting the bonuses actually paid by Merrill in December 2008, after the shareholders of BofA had approved the merger. These bonuses totaled $3.62 billion, paid by a company, Merrill, that reported a net loss of $15.3 billion for the fourth quarter of 2008 and a net loss of $27 billion for all of 2008:

“Approximately 39,400 employees at Merrill Lynch received [bonus] awards. . . . Merrill paid year-end bonuses for 2008 of $1 million or more to nearly 700 employees, $5 million or more to over 50 employees, and $10 million or more to over 10 employees. . . . Among those who received year-end bonuses for 2008 at Merrill were employees who were not retained after the closing of the merger.”

Statement ¶ 49.

B. Cuomo’s Complaint

While the papers filed by the Commission in support of its second settlement with the Bank have the tenor one would expect from a Commission filing, particularly one negotiated with the defendant — staid, measured, and largely colorless — Attorney General Cuomo’s complaint filed against the Bank and its two principal officers, Ken Lewis and Joe Price, is anything but: it is hard-hitting, colorful, and dramatically lays out facts it alleges justify a finding of fraudulent practices engaged in by the defendants. From the Commission’s papers we get firmness but civility; from Cuomo we get a Bronx cheer. And one thing is for certain, Cuomo’s complaint has caused and will cause the Commission and the Bank massive heartburn.

1. Treatment of the Bank’s Failure to Disclose Merrill’s Fourth Quarter Losses

A good illustration of the dramatically different pictures painted by the Commission and Cuomo’s office from the same facts is their treatment of BofA’s failure to disclose Merrill’s fourth quarter losses prior to the special meeting of the Bank’s shareholders held on December 5, 2008 to approve the Merrill merger. For the third quarter of 2008, ended September 30, Merrill reported net losses of $5.2 billion. This figure was publicly reported and incorporated by reference into the proxy statement distributed to the Bank’s shareholders in connection with the merger. Between the third quarter and the date of the meeting, December 5, Merrill incurred net losses of in excess of $7.5 billion, which were not disclosed by the Bank to its shareholders even though the Bank was well aware of them. It was this failure that triggered the Commission to file its second complaint against the Bank, on January 12, 2010, which complaint is also being resolved by the second settlement.

After announcement of the proposed merger on September 15, 2008, the Bank sent hundreds of employees to Merrill’s offices in New York to facilitate the anticipated merger. BofA’s Chief Accounting Officer, Neil Cotty, even moved into an office at Merrill’s headquarters. The Bank received daily reports of Merrill’s financial results. It learned shortly after October 31, 2008 that Merrill had incurred losses before taxes of $6.1 billion for October (and net losses of $4.5 billion). The $4.5 billion monthly net loss almost equaled the $5.2 billion loss that Merrill had reported for the entire third quarter of 2008. When Cotty learned of this loss, he forwarded an email to Joe Price that noted: “Read and weep.” SEC Statement ¶ 15.

After learning of the October 2008 loss, Price sought the advice of the Bank’s general counsel, Timothy Mayopoulos, on the Bank’s disclosure obligations. Here is how the SEC describes the deliberations conducted by Mayopoulos with the Bank’s outside counsel, Wachtell Lipton, and Bank executives (the Bank waived the attorney-client privilege thereby permitting such inquiries on October 12, 2009):

“Over the next several days, Mayopoulos, Price, and other executives and in-house attorneys at Bank of America conferred amongst themselves as well as with Edward Herlihy, Nicholas Demmo and other attorneys at Wachtell Lipton to determine whether a disclosure was required in light of the forecasted $5 billion quarterly loss at Merrill. . . . Notes of a Wachtell Lipton attorney reflect that the initial view of the lawyers on November 13 was that there should be some additional disclosure. . . . Thereafter, the attorneys and executives reviewed and analyzed, among other materials, Merrill’s results in the preceding six quarters, analyst estimates for Merrill’s results in the fourth quarter, as well as the Proxy Statement and other recent Bank of America and Merrill public filings that were available to shareholders. . . . On November 20, the lawyers concluded that no additional disclosure was required. . . . Price informed Lewis of the conclusion reached by the lawyers.”

Statement ¶ 18 (record citations and footnote omitted).

Contrast this rather antiseptic description with the recitation found in Cuomo’s complaint. Cuomo alleges that Mayopoulos’ initial reaction was that the Merrill losses ought to be disclosed: ‘[m]y reaction was that $5 billion is a lot of money, and I believe my initial reaction was that a disclosure was likely warranted.’” Complaint ¶ 75. The Complaint details the conversations Mayopoulos had with Wachtell partners concerning disclosure of the anticipated fourth quarter losses, including reciting from counsel’s notes (Wachtell obviously joined BofA and waived its attorney work product privilege). At a November 13, 2008 conference call that Mayopoulos held with Ed Herlihy, Eric Roth, and Nick Demmo of Wachtell, the Complaint alleges that “[d]uring this meeting, the parties agreed disclosure was the proper course, and they discussed both the disclosure’s content and the date of disclosure.” Complaint ¶ 82.

After the November 13th meeting, Mayopoulos reconsidered his conclusion on the disclosure of the anticipated fourth quarter 2008 Merrill losses. He concluded, based upon Merrill’s reported quarterly losses since the fourth quarter of 2007, ranging from $2 billion to $10 billion, that disclosure of the anticipated $5 billion fourth quarter loss (Mayopoulos, based on his conversations with other Bank executives, had concluded that November 2008 would be flat for Merrill) was not necessary, as it would “be well within the range of prior experience at Merrill Lynch, and that investors, based on that, would not be surprised by that result.” Complaint ¶ 86. He reached this conclusion notwithstanding that, as the SEC recounts, analysts covering Merrill issued reports after Merrill’s reported Q3 2008 net loss of $5.2 billion that projected that Merrill’s fourth-quarter performance would be an improvement over the third quarter, with some projecting that Merrill would report income and others reporting much more modest losses. Statement ¶ 13. Indeed, even Ken Lewis and Joe Price expected Merrill to break even in the fourth quarter. Id.

The last that Mayopoulos conferred with Wachtell about disclosure was November 20, 2008. Here is what Cuomo alleges about that conference call:

“Significantly, Wachtell played a limited role on the question by this time. After their original conclusion [from November 13] was disregarded, Wachtell lawyers took themselves out of the equation, doing no substantive work, and in fact simply agreeing with Mayopoulos. They issued no memoranda or work product and they did no further research. Herlihy testified that Mayopoulos ‘had done a lot of homework and thought it through and so had come to some conclusion with respect to the disclosure.’

Neither Wachtell nor the Bank ever consulted Roth [a Wachtell partner] again on the question. Roth was the lawyer closest to the issues involved in disclosure. He was the lawyer most involved in the analysis of the question, as the only one who had done any research in the area or talked to other lawyers about the litigation of such questions. He was left to think that disclosure would be made:

Question: So what was your understanding of what was going to happen on November 13, 2008 when that conversation ended?

Roth: My sense was that as of the close of that meeting the view was that some kind of trend disclosure would be made — or at least that was the recommendation that was being made to the business people. I have no reason to believe the business people wouldn’t agree with the lawyers’ advice — and that Price would go talk to the senior executives of Merrill about the concept.

But after November 13, he was no longer involved, except to hear that the trend disclosure was never made:

Question: What is the next thing that happened with respect to the disclosure of the Merrill Lynch loss issue after November 13, 2008?

Roth: In terms of what I did [on disclosure], I had no involvement in the consideration or discussion of this issue after November 13 and prior to January 15 with the client. [...] I believe that at some point prior to January 16 I had a conversation with Ed Herlihy where I inquired after the trend disclosure and what had happened. [ ... ]

Question: What did Mr. Herlihy say?

Roth: He told me […] that the client had decided that it was not necessary for the companies to make that disclosure.”

Complaint ¶¶ 92-93.

The contrast between the Commission’s treatment of BofA’s solicitation of Merrill’s advice on the disclosure of Merrill’s fourth-quarter losses was also dramatic. After the November 13, 2008 conference call Mayopoulos had with the Wachtell lawyers, it was agreed that Price would contact Merrill’s CEO, Thain, concerning disclosure of Merrill’s fourth-quarter losses. As described by the SEC: “Price also approached Thain and Nelson Chai, Merrill’s then-Chief Financial Officer, to suggest that a disclosure may be required. Thain and Chai rejected the suggestion, suggesting that Merrill ordinarily did not provide shareholders with interim disclosure in the middle of a quarterly period.” Statement ¶ 17.

Here is how Cuomo describes Price’s approach to Thain and Chai:

“Although, as Roth’s notes reflect, Price was to ‘engage’ Merrill Lynch, instead he [Price] avoided the issue by watering it down to a mere question. On November 14, Price met with Thain, Cotty [BofA’s Chief Accounting Officer], Chai and Hayward [Merrill’s Finance Director] at Merrill’s New York offices to analyze Merrill’s assets and financial condition. Price did not act on Mayopoulos’ advice to tell Thain that Bank of America would be disclosing Merrill losses. Rather, he merely asked Thain and Chai if Merrill would be making any disclosures regarding Merrill’s fourth quarter losses. Price recalled that he ‘asked that they assess any potential need to early disclose financial results and we would do the same, it would come back together.’

Hayward explained that there was only ‘a very short comment from Joe Price to the effect — not verbatim, but to the effect — does Merrill plan to do any intra-quarter disclosure, and John [Thain] responded, No, we don’t provide intra-quarter guidance, had not been doing that all year and didn’t plan to.’”

Complaint ¶¶ 83-84.

On December 3, 2008, just two days before the shareholder vote on the merger, by which time the fourth quarter loss was projected to be $8.9 billion, the SEC, in a footnote in its Statement, notes that Jeffrey Brown, the Bank’s Treasurer, raised with Price “the possibility of disclosing Merrill’s fourth quarter losses; after Price advised Brown that he had consulted the Bank’s attorneys on the issue, Brown suggested that, as a practical matter, disclosure may be advisable.” Statement ¶ 18, note 5.

Cuomo’s description of the interaction is more dramatic:

“Corporate treasurer Jeffrey Brown became concerned about the mounting losses at Merrill and the devastating effect they would have on the Bank of America shares he and others held. As he put it,

Associates are shareholders, as well. We had paid a lot for Merrill Lynch, and we were also watching before our eyes their financial condition deteriorate. You knew that there was likely to be adverse impacts to the share price, and that wasn’t necessarily a good thing as a shareholder.

Brown voiced this concern to Price before the shareholder vote, saying that he believed the losses ought to be disclosed to shareholders. Brown told Price that ‘I felt that we should disclose; that the losses were meaningful enough.’ He explained that ‘at this point it’s about a $9 billion after tax number. That’s a fairly significant loss for a corporation to experience in one quarter, and withholding that could potentially result in items like we’re discussing today [in his deposition].’ After Price dismissed Brown’s concerns, Brown offered an unforgettable warning: ‘I stated to Mr. Price that I didn’t want to be talking through a glass wall over a telephone.’”

Complaint ¶¶ 137-138.

2. Mayopoulos’ Firing

One of the areas Judge Rakoff showed an interest in at the hearing on the second settlement held February 8, as reported by the New York Times, was the firing of general counsel Mayopoulos. The SEC does not mention the firing at all in its Statement of Facts or its supporting papers. While its relevance is not clear, the recitation of the firing in Cuomo’s complaint adds to the drama of the tale it relates. As indicated above, Mayopoulos played the good trooper in his revised conclusion that disclosing Merrill’s anticipated fourth quarter losses in the Bank’s proxy statement was not necessary since they were within the range (as he then understood the actual losses after September 30, 2008) of Merrill’s quarterly losses reported since the fourth quarter of 2007. Mayopoulos had also been consulted by Price and Greg Curl, the Bank’s Vice Chairman of Corporate Development (and lead negotiator for the Bank on the Merrill merger) on whether, in light of Merrill’s fourth quarter losses, the Bank might invoke the “MAC” (material adverse change) clause of the merger agreement and back out of the merger. Mayopoulos advised that successfully invoking the MAC clause was unlikely.

After the merger, the Bank’s board met on December 9, 2008. Price reported to the board that Merrill’s projected net loss for the fourth quarter of 2008 was now $9 billion, some $2 billion higher than Price had previously told Mayopoulos was the expected fourth quarter loss. Right after the December 9 board meeting, Mayopoulos sought out Price to discuss the higher figure. Price was unavailable, so Mayopoulos planned to talk to him the following day with his question. Here is how Cuomo details Mayopoulos’ firing:

“Thus on the evening of December 9, Mayopoulos knew too much: first, that he had been approached before the shareholder meeting about the MAC; second, that on December 3, prior to the shareholder vote, he was told losses were only $7 billion after tax, and third, he now knew that by that time the losses had been at least $9 billion.

The next day, December 10, without any warning, Mayopoulos was told his employment had been terminated, and he was immediately escorted from the premises by an HR executive. He was not permitted to remove any belongings, even personal effects.
. . . .
Bank of America thus fired its General Counsel in the middle of a historic financial crisis, and in the course of the most significant acquisition in its corporate life. As Mayopoulos recalled in his congressional testimony,

I was stunned. I had never been fired from any job, and I had never heard of the general counsel of a major company being summarily dismissed for no apparent reason and with no explanation.
[…]

Finally, I could not understand why I was dismissed so abruptly. I was surprised that I was given no opportunity to say goodbye to my colleagues and staff, and why there was no orderly transition of my work to Mr. Moynihan. [Brian Moynihan, then head of the Bank’s Global Corporate Investment Bank and now CEO of the Bank.] No one, including Mr. Moynihan, ever contacted me to discuss what I had been working on. Nearly a year later, I still do not know why I was terminated, who was involved in the decision to do so, or what their reasons or motivations were.”

Complaint ¶¶ 156-157, 161.

3. The Bank Extracts $20 Billion from the Government

A good portion of Cuomo’s complaint is devoted to the Bank’s allegedly fraudulent extraction of $20 billion from the Government to support the Merrill merger. The thrust of the allegations is that the Bank, Lewis, and Price falsely claimed to Treasury Secretary Paulson and Fed Chairman Bernanke that the Bank could back out of the merger by reason of the MAC clause, due to the unanticipated losses suffered by Merrill during the fourth quarter of 2008, and that it could only proceed with the merger with taxpayer assistance. The detailed allegations make for fascinating reading, and certainly do not cast a favorable light on Lewis, Price, or counsel, but the relevance of the allegations is not entirely clear, given that neither Paulson nor Bernanke was fooled — they saw the argument as a negotiating tactic and probably without foundation — and, as we now know, the Bank in December 2009 repaid not only the $20 billion the Government invested in the Bank to assist with the Merrill merger but also the other $25 billion in TARP monies invested by the Government in the Bank.

But here is some of the gory detail.

The thrust of Cuomo’s allegations, which do serve to emphasize the weakness of the Bank’s position in failing to disclose Merrill’s fourth quarter losses to its shareholders prior to the shareholder vote, is that the Bank tried to use the very same losses that it concluded were not necessary to disclose to its shareholders as grounds for claiming Merrill had suffered a “material adverse change” and therefore would be justified in backing out of the merger! As Cuomo alleges:

“Thus, only the remaining $1.4 billion represented losses incurred after the shareholder vote but prior to December 12 [when the Bank embarked on MAC discussions with the Government]. In other words, BoA management sought taxpayer aid to save the Bank on a figure that was in reality only $1.4 billion worse than the losses they concealed from shareholders voting on the Merrill acquisition. Their action demonstrates, perhaps more clearly than any other fact, the materiality of the pre-vote losses, and BoA management’s obligations to disclose them.”

Complaint ¶¶ 167 (emphasis in original).

Moreover, both the Bank’s general counsel, Mayopoulos (by now having been fired), and the Wachtell firm advised the Bank against invoking the MAC clause. In another illustration of why it is never a good idea to waive the attorney-client or attorney work product privileges, Cuomo details Wachtell’s advice on the MAC clause to the Bank:

“Wachtell concluded right away that invoking the MAC clause would likely fail, and worse, could put the Bank at huge risk of being forced to purchase a bankrupted Merrill Lynch. On December 14, Roth took notes of a conversation with Demmo [another Wachtell partner] in which he noted ‘If we call the MAC company = bankrupt damage = huge,’ which he testified meant that ‘given the state of the financial markets, just the assertion that Merrill had suffered a MAC would probably result in counterparties refusing to deal with Merrill, and, as we saw with Lehman, it may not survive a day.’ The notes also reflect that the initial thinking included government aid: ‘Go to gov’t to share pain? Get addl cap.’ Roth testified that this note reflected Demmo’s thinking ‘that one possible course of action to consider would be the prospect of going to the government and getting some form of assistance.’ Moynihan likewise testified that going into the meetings with the federal officials, a potential solution to the situation was obtaining government aid.”

Complaint ¶ 182.

Demonstrating the dexterity lawyers are capable of, Wachtell’s advice to its client did not prevent it from forcibly arguing to the Government that the Bank could successfully invoke the MAC clause with Merrill and back out of the deal:

“The very lawyers who concluded that a MAC claim would be futile and disastrous argued forcefully to federal officials that a MAC case would be successful. Brenner [the Bank’s Associate General Counsel] described the December 19 meeting [with Paulson and Bernanke] to Moynihan as follows:

Eric [Roth] made a very strong case as to why there is a MAC. All questions (other than one) came from Tom Baxter at the NY Fed and focused on the case law around MAC. Since Eric or Peter [Hein] [of Wachtell] were involved in each case Tom cited, no line of questioning evolved very well for Tom. Tom observed there had never been a successful MAC case before, and Eric responded that all cases are factually based, and this one essentially could be the first due to magnitude and duration of future lost earnings.

In other words, even though it knew a MAC claim was out of the question, the Bank threatened federal officials that it would make one anyway, in order to get taxpayer aid.”

Complaint ¶ 200.

C. Thain’s Reputation Restored?

John Thain should thank Judge Rakoff for his rejection of the August 2009 settlement between the SEC and BofA. As a result of the rejection, the Commission was forced to develop and disclose the record of the deal and the negotiations conducted between the parties in connection with the merger. That record establishes that Merrill (and Thain) did not conceal relevant information concerning the payment of 2008 fourth quarter bonuses to Merrill’s employees or the losses incurred by Merrill for the fourth quarter of 2008.

Lewis fired Thain on January 22, 2009. The firing, widely reported, came in a visit Lewis paid to Thain in New York, and was delivered in a meeting that lasted less than 15 minutes. Officially, all that the Bank stated, in its press release announcing Thain’s departure, was that he was “leaving the company.” Most of the release was devoted to Moynihan’s elevation to President of Global Banking and Global Wealth and Investment Management (replacing Thain). (Moynihan would eventually replace Lewis as CEO of the Bank in December 2009.)

The dirt came in the press reports, which obviously relied upon Bank representatives for their information. Thus, the New York Times, in its report on the termination of January 23, 2009, noted that despite Merrill’s mounting losses over the fourth quarter, it “rushed to pay annual bonuses to its employees before its deal with Bank of America closed on Jan. 1.” While noting that Merrill did alert the Bank in “mid-December” that its losses were ballooning, the Times reported that “Mr. Lewis did not hear the news from Mr. Thain, who around that time left for a skiing trip at his second home in Vail, Colo.” Ouch!

Another reason for the termination, reported the Times, “may have been the decision by Mr. Thain to make an earlier-than-usual bonus payout to Merrill employees, just three days before the merger closed, and before Bank of America could do anything to prevent it.” Thain, following corporate etiquette, “declined through a spokeswoman to comment on whether he had misrepresented Merrill’s risks at the time of the merger.”

But, as the SEC’s Statement of Facts (for which BofA formally acknowledged there was “an evidentiary basis”) and Cuomo’s Complaint make clear, the Bank was well aware of Merrill’s mounting losses during the fourth quarter of 2008 (on a daily basis), agreed with Merrill that it could pay up to $5.8 billion in bonuses for 2008, and was aware of and did not object to the payment of the bonuses actually awarded prior to year end. SEC Statement ¶¶ 33, 39-40, 47; Complaint ¶¶ 236-40.

This is not to say that Thain’s termination was not inevitable. The captain goes down with the sinking ship. With its massive fourth quarter 2008 losses and the outrage that greeted its payment of billions in bonuses, it is no surprise that Lewis “suggested” Thain leave the combined company. What is clear is that the request was not prompted by any failure of disclosure by Merrill or Thain to BofA.

D. What Will Judge Rakoff Do?

As indicated, on Monday, February 8, Judge Rakoff held a preliminary hearing on the second settlement, and, in his fashion, voiced some skepticism. The Judge has now issued his order, on February 11, requesting additional information and certain clarifications concerning this second settlement. This one is not over.

First, for the easy part: the Judge requests the parties to indicate whether they would agree to modifications of the prophylactic provisions of the settlement to permit Court intervention if the parties (the SEC and the Bank) do not agree on the appointment of (i) the independent auditor to conduct the disclosure controls and procedures certification, (ii) disclosure counsel to be retained by the audit committee, or (iii) the independent compensation consultant to be retained by the compensation committee of the BofA board of directors. In any such instance, Judge Rakoff is suggesting the prophylactic provisions be modified to permit the Court to make the choice if the parties are unable to do so. I would anticipate that neither the Commission nor the Bank will have any objection to these suggested revisions to the prophylactic provisions of the settlement.

The Judge also requests clarification that the distribution of the $150 million civil fine not be made to “legacy Merrill Lynch” shareholders of the Bank, meaning those formerly Merrill shareholders who received BofA stock in the merger. No surprise here.

Where things get very dicey is with the Judge’s request for all underlying evidence for his review on the following matters:

• The Mayopoulos termination;

• Wachtell Lipton’s participation, if any, in the “evaluation of the disclosure issues raised by the reports of increased losses at Merrill Lynch & Co.”;

• All recommendations that the Bank disclose Merrill’s fourth quarter 2008 losses, including any from Mayopoulos, Wachtell Lipton, Merrill’s auditors, BofA’s “corporate treasurer,” or anyone else; and

• Similar information as to disclosure of the agreement reached by the Bank and Merrill vis á vis the payment of 2008 bonuses.

The Judge asks for the underlying evidence relating to the above-referenced matters, requesting that the parties “jointly and severally” arrange the evidence in accordance with the Judge’s listing of the topics he is interested in. He does not call for any argument on the question he is obviously interested in, namely, whether there is any culpability by any individuals for the alleged disclosure violations by the Bank.

The order requires the parties to make their submissions to the Court by no later than 5 p.m. on Tuesday, February 16, 2010. There goes the Presidents’ Day holiday for counsel to the Commission and the Bank. It is safe to say they must all be muttering under their breath about their blown weekend and what Judge Rakoff is up to.

We shall soon see.

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

2010-01-21T11:30:00.000-08:00

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.

SEC v. Bank of America Corp.: Recent Developments

2010-01-15T09:38:00.000-08:00

This case is headed for trial on March 1, 2010 before Judge Rakoff. Two recent decisions by the Judge have sharpened the issues for trial. Whether the case actually is tried is problematic, given BofA’s obvious attempts, under new CEO Brian Moynihan, to settle all litigation arising out of BofA’s acquisition of Merrill Lynch.

A. Judge Rakoff’s Evidentiary Ruling of January 4

I have commented extensively on this case in prior posts. As I have observed, BofA’s primary defense was to be that the fact that Merrill would pay substantial 2008 year-end bonuses to its officers and employees was so well known by the market that any failure to disclose BofA’s agreement that Merrill could pay such bonuses (of up to $5.8 billion) was immaterial.

By his January 4, 2010 Opinion and Order (“Order”) Judge Rakoff dealt with the SEC’s motion to exclude from evidence all media reports concerning Merrill’s payment of year-end bonuses. The Judge granted the motion. The ground for the decision was BofA’s own October 31, 2008 proxy statement, used to solicit the consent of its stockholders for the merger. BofA was hoisted on its own petard, as it cautioned its stockholders to rely only on the information set forth in the proxy statement and information specifically incorporated by reference into the proxy statement:

“You should rely only on the information contained or incorporated by reference into this document. No one has been authorized to provide you with information that is different from that contained in, or incorporated by reference into, this document.”

Order at 1-2.

To emphasize the point, BofA repeated this admonition, in even stronger language, in bold face type, at the end of its proxy statement:

“You should rely only on the information contained or incorporated by reference in this document. Neither Bank of America nor Merrill Lynch has authorized anyone to give any information or make any representation about the merger or our companies that is different from, or in addition to, that contained in this document. Therefore, if anyone does give information of this sort, you should not rely on it.”

Order at 2.

These disclosures provided the Judge with all he needed to grant the SEC’s motion to exclude all media reports from evidence, including any reliance on such reports by both the SEC’s and BofA’s experts.

“Furthermore, even if the media reports of Merrill’s likelihood of paying bonuses could otherwise somehow be said to bear indirectly on the question of how material was the Bank’s alleged failure to disclose that it had in fact already approved the payment of such bonuses when it purported to represent that it had not given such approval, the warnings in the proxy statement totally changed the relevant mix of information for assessing materiality. Since the test of materiality is whether the undisclosed information, if disclosed, “would have been viewed by a reasonable investor as having significantly altered the ‘total mix’ of information made available,” TSC Indus., 426 U.S. at 438, one must ask what a reasonable investor would reasonably consider the total mix of information in this case. The answer is that since the Bank itself warned investors not to rely on the media, it would be unreasonable for a shareholder to consider the media pronouncements to be a part of the relevant mix of information.”

Order at 5.

As is his want, Judge Rakoff could not resist putting in a final dig at BofA for its position:

In effect, the Bank is arguing that, even though it expressly warned its shareholders to disregard the media, it can now defend itself by asserting that a reasonable shareholder would have disregarded these warnings and, by consulting the media, perceived that the Bank’s alleged lies were immaterial. Even a zealous advocate might perceive that such an argument hints at hypocrisy.”

Order at 6.

B. The Judge Rejects the SEC’s Request to Amend Its Complaint

By his order of January 11, the Judge rejected the SEC’s attempt to amend its Complaint to add an additional alleged omission by the Bank, namely its purported failure to disclose Merrill’s sizeable losses incurred in the fourth quarter of 2008. Apparently the Judge was convinced this new claim was brought too late and would prejudice BofA. For our purposes it is a sideshow; its exclusion from the case doesn’t detract from the drama that is unfolding in Judge Rakoff’s court.

On January 13, the SEC filed a new complaint, also in the Southern District, against BofA repeating its allegations of proxy violations for BofA’s failure to disclose Merrill’s sizeable fourth quarter 2008 losses. While I am not familiar with the Southern District’s assignment procedures, this action could very well be deemed a “related” case to that pending before Judge Rakoff and therefore assigned to him. If so, the SEC’s filing of this second action against BofA may have strategic implications: one or both parties may request a delay in the March 1 trial date of the current action before Judge Rakoff so that both actions, clearly involving similar facts, documents, evidence, and witnesses, be tried at the same time. The SEC may also believe that the second action gives it additional leverage over BofA.

C. Prognosis

I discussed in some detail my prognosis for any trial in this case in my post of September 25, 2009 and concluded, “it’s entirely possible that even if the Bank is found liable for proxy violations as alleged by the SEC, the remedies Judge Rakoff would enter would not be as stringent as those set out in the settlement to which BofA was prepared to accept.” The settlement Judge Rakoff rejected called for payment of a civil fine by BofA of $33 million and entry of a permanent injunction against future violations of the proxy rules.

We now know, after extensive discovery, including of BofA’s lawyers (BofA waived the attorney-client privilege - see my post of October 15, 2009), that the SEC’s initial conclusions based upon the discovery it conducted prior to entering into the settlement, that the record did not establish scienter on the part of any officer of BofA or its counsel, sufficient to allow the SEC to name any such persons, have been confirmed, at least in the SEC’s mind. So the Judge’s outrage at the settlement for its failure to name any individual culprits will not be vindicated at trial. Assuming, as appears likely to this observer, that the Bank will be found liable for a proxy violation for failing to disclose its agreement with Merrill to pay year-end bonuses of up to $5.8 billion, what remedies will Judge Rakoff impose?

Given the sensitivities of the Judge to imposing upon the “victim,” here BofA’s shareholders, any damages for BofA’s proxy violations, it is entirely reasonable to conclude that the most probable remedy Judge Rakoff would impose is an injunction. As I discussed in my post of September 25, even on that remedy the Bank will mount a vigorous defense, namely on the ground that the odds of its repeating a proxy violation are nil.

The Judge is of course very bright, and probably appreciates that this case is headed in that direction so he may be more amenable to accepting the next settlement BofA and the SEC agree to. This leaves open the possibility that BofA will enter into a global settlement with the SEC and New York’s Attorney General Andrew Cuomo that includes the payment of a fine (to the extent demanded by Cuomo) and a consent to injunctive relief against future violations of the proxy rules. Given there’s a new captain of the BofA ship, CEO Moynihan, I am reasonably confident that is a settlement he would gladly accept to get the Merrill litigation behind him.

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

2010-01-13T15:38:00.000-08:00

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.

In Re John Q. Hammons Hotels Inc. Shareholder Litigation: Bringing Coherence to Delware's M&A Law Involving Controlling Shareholders?

2009-11-28T14:58:00.000-08:00

Much of the march of corporate governance law, as with civilization generally, is to restrain the excesses of the powerful. An illustration is Chancellor Chandler’s important decision in In Re John Q. Hammons Hotels Inc. Shareholder Litigation, 2009 WL 3165613 (October 2, 2009). The Chancellor’s decision is in response to cross motions for summary judgment, and comes some four years after the challenged merger closed on September 16, 2005. In the course of his decision, the Chancellor articulates standards for “majority of the minority” stockholder votes that in certain circumstances would permit the application of a business judgment rather than an entire fairness standard of review for interested-party mergers, applies strict standards to the disclosure of conflicts involving a special committee’s advisors, and applies a surprisingly expansive standard to an aiding and abetting claim against an unaffiliated buyer.

A. John Q. Hammons and His Eponymous Company

John Q. Hammons controlled John Q. Hammons Hotels, Inc. (the “Company”). The Company, an owner and manager of hotels, when public in 1994. It had two classes of stock, Class A and Class B. Hammons and his affiliates owned 5% of the Class A shares and all of the Class B shares, the latter of which had super voting rights. Through his stock holdings, Hammons controlled 75% of the voting power of the Company.

The hotels were owned and operated by a limited partnership of which the Company was the sole general partner. The Company owned a 28% interest in the limited partnership; Hammons owned the remaining the 72% interest (as a limited partner) in the partnership.

Hammons is obviously old school, regarding the trappings of corporate governance as a nuisance. Thus –

• He “disliked the procedural requirements associated with public stockholders and a board of directors, . . . (Slip Opinion at 6).

• He hired the Company’s President in 2001 “without consulting the Board . . .” Id.

• The Company had numerous related party transactions with Hammons: he owned a hotel management company that provided accounting and other administrative services to the Company; owned a 50% interest in the entity from which the Company leased its corporate headquarters; utilized the Company for administrative and other services for his outside business interests (for which he reimbursed the Company); utilized the services of Company employees in his personal enterprises; and owned real estate underlying one of the Company’s hotels that the Company leased from him.

• He threatened legal action against the Board to prevent it from pursuing the sale of certain hotels that the Board concluded were no longer “core assets” of the Company.

• He entered into a side agreement with a broker retained to sell one of the Company’s properties, which granted Hammons a right of first refusal, without disclosing the agreement to the Board.

B. Merger of the Company

Consistent with his style, in early 2004 Hammons informed the Board that he had begun discussions with a third party regarding a sale of the Company and/or his interest in the Company. Hammons’ hand-picked suitor offered $13 per share for all of the outstanding Class A shares. The deal included extensive agreements with Hammons to accommodate his desires to avoid taxation of the disposition of his interest in the Company, to provide him with financing to continue his development of hotels, and to grant to him, by distribution from the buyer, one of the Company’s premier properties.

The deal with the initial suitor eventually went away. The deal that was done, and is the subject of this litigation, was done with affiliates of Jonathan Eilian, an unaffiliated third party. Eilian eventually negotiated a deal whereby his acquisition vehicles would pay $24 in cash per share to the Class A stockholders and accommodate Hammons’ tax, line of credit, and property desires. The deal was negotiated by a special committee of the Company’s board, comprised of independent directors, who retained Lehman Brothers as its financial advisor and the Katten Muchin firm as its legal advisor.

C. Critical Facts

The special committee negotiated with Eilian a not uncommon protection for the minority stockholders, namely, that the deal be approved by a majority of the Class A shareholders of the Company other than Hammons and his affiliates, but, as it turns out, the agreement was deficient in two respects: the condition was to secure the approval of a majority of the Class A shares voting on the merger, and the condition was waivable by the special committee.

As an illustration of why principals should restrain their deal analysis in public, the record in this case included Eilian’s description, in an email sent during the negotiations, of his observation that Hammons practiced a “liberal” mixing of private and personal expenses and competitive interests; and, in one of his early letters to the special committee, his recognition of the “perceived conflicts of interest with the controlling Class B shareholder [Hammons]” as one explanation for the underperformance of the Company’s shares. Further, in an early presentation of his proposal for acquiring the Company, Eilian cited “unique issues of [the] controlling shareholder” as one source of the Company’s trading discount. Slip Opinion at 45. (Prior to merger rumors, the Company’s shares traded in the $4 to $7 range. It went public at $16.50 per share in 1994).

Two facts of interest here turned out to be relevant to the plaintiffs’ claims of nondisclosure: Katten Muchin represented the lender that provided the financing for Eilian to do the deal, and Lehman sought to play a role in Eilian’s planned refinancing of the Company’s debt. Neither alleged conflict was disclosed in the Company’s proxy statement, although Katten Muchin did secure a waiver from the special committee for its joint representation of the board and the buyer’s lender (the deal team and the loan team at Katten Muchin were separate). (Lehman did not get Eilian’s business, and asserted that the group at Lehman that solicited Eilian’s business was different from the group that worked for the Company.)

D. The Stockholder Vote

In a special meeting of stockholders held September 15, 2005, 72% of the outstanding Class A shares voted to approve the merger (with 89% of the Class A shares that voted voting to approve the merger).

E. Standard of Review: Entire Fairness or Business Judgment?

This was the threshold issue the Chancellor confronted in considering the cross motions for summary judgment. Looming over the decision was the Delaware Supreme Court’s decision in Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994), which mandates the application of an entire fairness standard of review to an interested cash-out merger by a controlling or dominating shareholder. The Chancellor concluded that Lynch did not mandate entire fairness review here because the buyer, Jonathan Eilian, “had no prior relationship with the Company or with Hammons” Slip Opinion at 25. No matter that Hammons secured separate benefits for himself from Eilian:

“The rights Hammons retained after the Merger – the 2% interest in the surviving LP, the preferred interest with a $335 million liquidation preference, and various other contractual rights and obligations – do not change that Eilian made an offer to the minority stockholders, who were represented by the disinterested and independent special committee. Put simply, this case is not one in which Hammons stood ‘on both sides of the transaction.’”

Slip Opinion at 25 (citing Lynch).

So the Chancellor moves on to a business judgment standard of review, correct? Incorrect. While Lynch does not mandate entire fairness review, the Chancellor nevertheless applied that standard of review here because of “deficiencies” in the procedures employed by the special committee in this deal. How so?

“In this case – which, again, I have determined is not governed by Lynch – business judgment would be the applicable standard of review if the transaction were (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.”

Slip Opinion at 29 (footnote omitted).

In an important footnote to this observation, the Chancellor emphasizes that the special committee cannot be just any special committee:

“Rather, the committee must be given sufficient authority and opportunity to bargain on behalf of the minority stockholders, including the ability to hire independent legal and financial advisors. Moreover, neither special committee approval nor a stockholder vote would be effective if the controlling stockholder engaged in threats, coercion, or fraud.”

Id. at 29 n. 38.

But why not apply the business judgment standard given that Hammons did not stand “on both sides” over the transaction? Because, observed the Chancellor, Hammons, by reason of his blocking position as controlling shareholder, and bargaining power, competed with the minority stockholders “for portions of the consideration Eilian was willing to pay to acquire” the Company. Id. at 30. Because of this fact, it was imperative that there be “robust procedural protections in place to ensure that the minority stockholders have sufficient bargaining power and the ability to make an informed choice of whether to accept the third-party’s offer for their shares.” Id.

F. The Chancellor’s Categorical Voting Rules

In explaining his conclusion that, to assure business judgment review (at least in interested party mergers not controlled by Lynch), namely, that the majority-of-the-minority vote be of all minority shares, and that the condition be non-waivable, even by the special committee, the Chancellor displays an appreciation for the pressures confronting special committees:

“To give maximum effect to these procedural protections, they must be preconditions to the transaction. In other words, the lack of such requirements cannot be ‘cured’ by the fact that they would have been satisfied if they were in place. This increases the likelihood that those seeking the approval of the minority stockholders will propose a transaction that they believe will generate the support of an actual majority of the minority stockholders. Moreover, a clear explanation of the pre-conditions to the Merger is necessary to ensure that the minority stockholders are aware of the importance of their votes and their ability to block a transaction they do not believe is fair.”

Slip Opinion at 31-32.

G. Hammons’ Veto Power and Unfair Dealing

Plaintiffs argued that by reason of Hammons’ veto power over any deal, the special committee was by definition “coerced” into accepting any Hammons-approved deal because, absent any such approval, the Company’s shares would sink back to their pre-merger trading level ($4 to $7 per share). The Chancellor rejected this structural coercion claim, primarily because of the proposition that, at law, Hammons, as a controlling shareholder, had no obligation to sell his shares or to agree to any transaction that would have adverse tax implications for him:

“The mere possibility that the situation would return to the status quo, something Hammons could have chosen to do by never considering selling his shares, is not, standing alone, sufficient ‘coercion’ to render a special committee ineffective for purposes of evaluating fair dealing.”

Slip Opinion at 35.

H. Self-Dealing and Share Price Depression

The Chancellor concluded that a trial is necessary to resolve the parties’ claims on fair dealing. And, in what surprised this observer, the Chancellor concludes that the plaintiffs could prevail at trial on their claim of unfair dealing “if they were able to establish that the price of the minority shares was depressed as a result of Hammons’ improper self-dealing conduct.” Slip Opinion at 35. If the pre-merger price of the Class A shares was depressed by such conduct, “then the special committee and the stockholders could have been subject to improper coercion, meaning they would have been coerced into accepting any deal, whether fair or not, to avoid remaining as stockholders.”

I. Disclosure Claims

As noted above, the Chancellor concluded that the Company’s failure to include in its proxy statement the potential conflicts to which Katten Muchin and Lehman were subject precluded summary judgment on plaintiffs’ disclosure claims, thus necessitating that the claims be tried. In rejecting the defendants’ motion on these disclosure claims, the Chancellor places heavy reliance on the importance of disclosure of potential conflicts of interest to which advisors may be subject:

“This Court, however, has stressed the importance of disclosure of potential conflicts of interest of financial advisors. Such disclosure is particularly important where there was no public auction of the Company and ‘shareholders may be forced to place heavy weight upon the opinion of such an expert.’ It is imperative that stockholders be able to decide for themselves what weight to place on a conflict faced by the financial advisor.”

Slip Opinion at 40 (footnotes omitted).

Similar concerns apply to the disclosure of conflicts to which legal advisors may be subject:

“Again, the compensation and potential conflicts of interest of the special committee’s advisors are important facts that generally must be disclosed to stockholders before a vote. This is particularly true, where, as here, the minority stockholders are relying on the special committee to negotiate on their behalf in a transaction where they will receive cash for their minority shares. Although the waiver of the conflict by the special committee may have resolved any ethical violation, the special committee’s waiver of the conflict would likely be important to stockholders in evaluating the Merger and in assessing the efforts of the special committee and its advisors.”

Slip Opinion at 42.

J. Aiding and Abetting

An aiding and abetting claim requires, among other things, knowing participation in a breach of fiduciary duty by the alleged aider and abettor. In another surprise for this observer, the Chancellor concluded that, by reason of Eilian’s “awareness” of Hammons’ conflicts of interest and alleged improper self-dealing, he was not entitled to summary judgment on plaintiffs’ aiding and abetting claim: “There remains,” concluded the Chancellor, “a material issue of fact as to whether Eilian was aware that [the Company’s] stock price was depressed as a result of Hammons’ improper self-dealing.” Slip Opinion at 45.

_____________________

So this case is headed for trial. While the parties attempted mediation prior to the filing of their summary judgment motions, unsuccessfully, one would assume that settlement discussions may resume in earnest now that Chancellor has teed this case up for a full-blown trial.

SEC v. Bank of America Corp.: Bank of America Asserts the Advice of Counsel Defense

2009-11-11T16:22:00.001-08:00

Following its October 12, 2009 decision to waive the attorney-client privilege as to communications between it (and Merrill Lynch) and their counsel regarding the disclosures concerning the payment of year-end 2008 discretionary bonuses, Bank of America took the next logical step and, in its answer to the SEC’s amended complaint, dated October 30, 2009, has now asserted, as an affirmative defense, that the Bank “reasonably and in good faith relied on counsel with respect to the matters alleged in the [SEC’s] Amended Complaint.”

So the Bank has come full circle, from taking the position, during the SEC’s investigation of its proxy statement disclosures, that it would not waive the attorney-client privilege while at the same time not formally asserting the advice of counsel defense, to now waiving the privilege and formally asserting the defense. The Bank was emphatic on these points in its briefs filed with the Court in support of its settlement with the SEC (now rejected by Judge Rakoff):

“In the August 25 Order, the Court also asked whether Bank of America had waived the attorney-client privilege by allegedly asserting that it relied on counsel. The answer is indisputably no for at least three reasons. First, no Bank of America or Merrill Lynch witnesses told the SEC that they relied on the advice of counsel with respect to the matter at issue here. At most, when asked, Bank of America and Merrill Lynch witnesses answered that they delegated to counsel the responsibility for preparing the Proxy Statement, including the section at issue here. Second, no Bank of America or Merrill Lynch witnesses revealed the content of any confidential communication with counsel. Third, neither Bank of America nor Merrill Lynch has ever invoked reliance on advice of counsel as a defense to a claim by the SEC in litigation.”

Bank’s Reply Memorandum, dated September 9, 2009, at 2 (footnote omitted).

A. So Why Assert the Defense Now?

I speculated in my post of October 15, 2009 that the Bank may have waived privilege in this case because of pressure it was receiving from other quarters, including Congress and New York Attorney General Andrew Cuomo. I also speculated, given that the decision on waiver went to the highest level at the Bank — its Board of Directors — that it would be surprising indeed if any of the privileged materials now to be disclosed would prejudice the Bank’s defense. In all events, once the Bank made the decision to waive the privilege as to communications between it (and Merrill) and their counsel — Wachtell (counsel to the Bank) and Shearman & Sterling (counsel to Merrill), why not assert an advice of counsel defense? After all, the Bank has consistently asserted that the drafting of the November 3, 2008 proxy statement was done by the lawyers and disclosure decisions were made by the lawyers. So why not let the lawyers defend the disclosures (and omissions) in the proxy statement?

But, as a technical matter, it’s not clear what the advice of counsel defense will do for the Bank. The SEC, in its amended complaint, which sharpens its allegations against the Bank, does not name any additional parties, including any officers of the Bank or any of the Bank’s or Merrill’s lawyers. “Scienter” is not an element of the SEC’s claim of proxy violations against the Bank. The SEC need not establish that the Bank, in omitting to disclose publicly its agreement with Merrill on the payment of year-end 2008 discretionary bonuses, was “conscious” of the violation or reckless in not disclosing the agreement in light of the requirements of the proxy rules. As the SEC explained in its initial brief in support of its settlement with the Bank:

“There is no scienter requirement for a violation of Section 14(a) of the Exchange Act and Rule 14a-9. A misleading proxy statement violates these provisions even if the company filing the statement ‘believed in perfect good faith that there was nothing misleading in the proxy materials.’ . . . Liability may be imposed based on negligent conduct. . . . (misstatements need not have ‘resulted from knowing conduct’ and ‘[l]iability can be imposed for negligently drafting a proxy statement’). As the Seventh Circuit explained in a recent case, negligence in this context simply describes the issuer’s failure to comply with the law: ‘Section 14(a) requires proof only that the proxy solicitation was misleading, implying at worst negligence by the issuer. And negligence is not a state of mind; it is a failure, whether conscious or even unavoidable . . . to come up to the specified standard of care.’”

SEC’s Memorandum, dated August 24, 2009, at 19 (citations omitted).

If the SEC need not establish scienter by the Bank to make out its claims of proxy rule violations by the Bank, then it is not clear what purpose the advice of counsel defense serves. You can’t justify driving 60 miles an hour in a 25-mile school zone on the ground that your lawyer told you it was OK. Similarly, even if Wachtell rendered a written opinion to the Bank that the omission of the year-end bonuses agreement articulated in the Disclosure Schedule to the Bank/Merrill Merger Agreement from the proxy statement was permissible under the proxy rules, that opinion would not exonerate the Bank from liability if Judge Rakoff finds that the proxy rules required disclosure of the agreement in the proxy statement.

The Bank’s position is that a violation of the proxy rules requires a finding of negligence, and that there was no negligence in the drafting of the BofA/Merrill proxy statement:

“The Proxy Statement was drafted by expert counsel for both Bank of America and Merrill Lynch. It followed the state-of-the-art custom and practice in the legal industry.”

Bank’s Memorandum, dated August 24, 2009, at 27.

Perhaps the Bank intends to rely on the advice of Wachtell to establish that it was not negligent in omitting to disclose the agreement on payment of year-end 2008 discretionary bonuses from the proxy statement. But, as the Seventh Circuit observed in Beck v. Dobrowski, 559 F.3d 680, 682 (7th Cir. 2009), “Section 14(a) requires proof only that the proxy solicitation was misleading, ….” What BofA’s or Merrill’s counsel may have opined on that question should be irrelevant to this question.

B. What Proffering the Defense Will Do

Make life uncomfortable for a lot of lawyers. With the Bank’s waiver of the privilege, the SEC will be reviewing a lot of documents and emails by Wachtell and Shearman & Sterling (as well as in-house counsel) relevant to the proxy statement disclosures. One or more of these lawyers may be called to testify at trial, if a trial occurs. Such scrutiny cannot be welcome to transaction lawyers. And, of course, there is the risk that, if counsel consciously addressed the question of disclosing the agreement on payment of year-end 2008 discretionary bonuses, set forth in the Disclosure Statement to the Merger Agreement, in the proxy statement, and consciously decided not to do so, then such counsel could find themselves named as parties defendant to the SEC’s lawsuit against the Bank or brought up on separate administrative or civil proceedings by the Commission.

So the Bank’s waiver of the attorney-client privilege and its assertion of the advice of counsel defense cannot have sat well with the managing partners of Wachtell or Shearman & Sterling.

SEC v. Bank of America Corp.; Attorney-Client Communications to be Aired

2009-10-15T17:24:00.000-07:00

Two of the questions I posed in my post of September 25, 2009 have now been answered. Both the SEC and Bank of America have demanded trial by jury, and the Bank has decided to waive the attorney-client privilege as to communications relevant to the SEC’s complaint against the Bank.

The SEC was first to file a jury trial demand, followed by the Bank. While presenting a 100-page plus legal document to a jury for review is always a challenge, the fundamental question in this case – whether the Bank should have disclosed its agreement with Merrill to allow the payment of up to $5.8 billion in fourth quarter bonuses to Merrill employees – is straightforward, and it would not surprise this observer if the SEC relishes the prospect of having a panel of ordinary New Yorkers pass upon the compensation mores of Wall Street bankers. Perhaps also factoring into the SEC’s decision, and the Bank’s, is a concern over Judge Rakoff, who has demonstrated that he can be a loose cannon.

The Bank’s decision to waive the attorney-client privilege is more surprising, characterized as a “bombshell reversal” by The American Lawyer. Perhaps if the question of waiving the privilege involved only this case, the Bank would have maintained its position and not waived the privilege, but clearly more is at stake, including Congressional inquiries and the pressure being exerted by New York Attorney General Andrew Cuomo. As the Wall Street Journal reports, the “new more conciliatory legal approach is in part intended to pave the way to a settlement of various investigations, say people familiar with the matter.” WSJ, October 13, 2009 at C1, col. 2.

The Bank’s waiver is set forth in a stipulation with the SEC dated October 12, 2009, and is carefully drafted to limit the waiver only to those communications relevant to the matters at issue in the SEC’s complaint against the Bank. This restricted waiver responds to one of the concerns I expressed in my post of September 25 that any waiver could extend to other litigation. Judge Rakoff has accepted the stipulation, although characteristically he couldn’t resist editorializing, chastising the parties for draping the stipulation in “legalese – with the complete first sentence extending over two-and-a-quarter single-spaced pages and featuring no fewer than nine recitations of the word ‘Whereas’.” Order of October 14, 2009. As the Judge characterizes the stipulation:

“It would allow the Bank of America to waive attorney-client privilege and work-product protection regarding certain categories of information material to this case … without thereby waiving such privilege and protection regarding other information that may be of interest in related private lawsuits.”

The matter was of sufficient importance that it went to the highest decision-making level at the Bank – its Board of Directors. It is hard to believe that the Board would have made this decision without believing that none of the affected communications – emails and the like between the Bank and its lawyers, both in-house and at the Wachtell firm, and communications between Merrill and its in-house and outside counsel at Shearman & Sterling – will cast a bad light on either the Bank or its executives.

It may be a different matter for Wachtell. The New York Times, in its article on the waiver, reported that “Wachtell lobbied to keep its advice protected …” (NY Times, October 13, 2009 at B10, col. 6 (the same article quotes a spokesman for Wachtell as claiming the report of its opposition to a waiver to be “totally erroneous”).

The Bank’s position all along, as detailed in the SEC’s briefs in support of the settlement, now rejected by Judge Rakoff, is that it relied upon Wachtell to draft the October 31, 2008 proxy statement used to solicit the Bank’s shareholders to approve the Merrill merger, and that it was Wachtell that made the determination not to explicitly include the Bank’s agreement to permit the payment of up to $5.8 billion in year-end bonuses in the proxy statement itself rather than just in the disclosure schedule included as part of the merger agreement (but not filed with the SEC or made publicly available). So disclosing all attorney-client communications between the Bank and Wachtell can only create discomfort for the firm, and separate it from the Bank.

I surmised in my post of September 3, 2009 there are at least three possible explanations for the Bank’s (or, according to the Bank, Wachtell’s) failure to disclose the Bank’s bonus agreement with Merrill in the proxy statement itself:

“(i) The parties, concerned over the reaction by BofA’s stockholders to any disclosure of the agreement on payment of year-end bonuses, deliberately buried their agreement on the payment of bonuses in the disclosure schedule;

(ii) The parties did not consider the agreement material and therefore concluded that no disclosure of it was necessary; or

(iii) The failure to disclose the agreement was a boot.”

If the new material discloses that Wachtell’s lawyers consciously decided not to disclose the bonus agreement in the proxy statement but leave it to the disclosure schedule, then the SEC could very well add the responsible lawyers to its complaint against the Bank as “aiders and abettors” of the Bank’s violations or as parties who “caused” the Bank’s violations. I speculated in my post of September 9 that the third possibility is the likely one, given the time pressures under which this deal was done: the omission of the bonus agreement in the text of the proxy statement was an oversight. It will be interesting to see what the disclosed materials reveal.

But then again, all of the materials may not be revealed. Uncommunicated work product by a lawyer, such as memos to file not distributed to the client, research memos, and internal communications, may not be within the reach of the Bank’s waiver. Generally, a law firm need not disclose uncommunicated work product, since that is a privilege of the firm, not the client, except in disputes between the client and the firm over the competence of the firm’s legal services. So it could very well turn out that Wachtell will resist emptying its files for the SEC, at least to the extent of uncommunicated Wachtell work product relating to the engagement. It is conceivable, therefore, that the mystery of why the Bank’s agreement with Merrill on the payment of year-end bonuses is included in the disclosure schedule but not in the proxy statement will remain a mystery.

What we can anticipate is the type of embarrassing disclosures that inevitably accompany the production of emails. It continues to astound this observer that individuals who should know better treat email communications like they do communications between fellow golfers in the steam room. Witness this email disclosure between otherwise sophisticated directors of the Bank (Charles K. Gifford and Thomas May) on January 15, 2009, made during a conference call among members of the Board and senior management about Merrill’s mounting losses:

[Gifford] “Unfortunately, it’s screw the shareholders !!”

[May] “No trail, ….”

[Gifford, responding to May’s admonition] “The context of a horrible economy !!! will effect everyone.”

[May] “Good comeback, …”

(NY Times, October 14, 2009, at B1, col. 4, and B4, col. 1)

With the production of attorney-client communications by the Bank, we can expect more of such embarrassing disclosures. Whether they prove more than just embarrassing will be the question.

SEC v. Bank of America Corp.: The Parties Head for Trial

2009-09-25T11:30:00.000-07:00

The parties’ decision to proceed to trial rather than appeal Judge Rakoff’s rejection of their settlement on September 14 surprised this observer. I had speculated in my post of September 15 that the parties would appeal. That they have not may be due to technical issues involving the rejection (it did not constitute a final decision) or it may be that the parties’ submissions and Judge Rakoff’s comments so stirred them up that they have concluded it’s time to strap on their holsters and enter the ring. Whatever is the explanation, the case is now headed for trial, scheduled to commence March 1, 2010. Each party will have many interesting decisions to make over the next few months, including:

A. Will the SEC Sue Additional Parties?

Judge Rakoff has set October 19, 2009 as the date by which the SEC, without leave of court, may amend its pleadings or add additional parties. Given Judge Rakoff’s severe criticism of the Commission for failing to pursue any individual officers of BofA or its counsel for the alleged misstatements and omissions in BofA’s October 31, 2008 proxy statement, will the Commission add as parties defendant any of BofA’s executive officers, BofA’s in-house counsel who worked on the proxy statement, or the Wachtell firm, which acted as BofA’s outside counsel?

I would be surprised if the Commission did so. The Commission has made clear in its filings in support of the settlement that it had developed no evidence establishing the requisite “scienter” or knowledge of wrongdoing by any of the executive officers of BofA or its counsel so as to justify adding any of them to the complaint. The Commission cannot simply run away from these assertions and now do what it said only weeks ago that it could not do:

“… the Commission investigated the relevant roles played by various senior officials and other individuals in the events surrounding Merrill’s payment of year-end bonuses and the related proxy disclosures. The Commission duly considered whether to allege additional charges against Bank of America and charges against individuals but determined that such charges were not sufficiently supported by the investigative record.”

SEC’s Memo of August 24, 2009 at 23.

“… there is an insufficient evidentiary basis to establish a prima facie case of the requisite scienter with respect to the lawyers for purposes of alleging secondary liability under the securities laws.”

SEC Reply Memorandum of September 9, 2009, at 14 (footnote omitted).

B. Will the Parties Request a Jury Trial?

Each of the SEC and BofA may request that the trial be held before a jury. Will they do so?

My guess is that the Commission would be satisfied with Judge Rakoff as trier of fact, whereas the Bank may be more inclined to present its case to a jury. The Bank’s strategy will clearly be to parade expert witness after expert witness (to the extent Judge Rakoff will allow them) and possibly fact witnesses to establish that all the world knew that Merrill intended to pay year-end bonuses in a substantial amount and at least equal to what it in fact did pay — $3.6 billion, a pittance by Wall Street standards (the SEC’s charge is that BofA did not disclose its prior agreement with Merrill that Merrill could pay up to $5.8 billion in fourth-quarter bonuses). The challenge is whether the Bank really wants a group of New Yorkers to dwell over the course of a trial upon the payment of billions in bonuses to Wall Street suits.

C. Will the Parties “Re-Settle” the Case Before Trial?

There is nothing to prevent the Commission and BofA to revise their settlement and present the revised settlement to Judge Rakoff for approval. What would that revision consist of?

The Commission could agree to eliminate the civil fine of $33 million, leaving only the permanent injunction against BofA’s commission of future proxy violations. Presumably BofA would not object to this, and on what grounds could Judge Rakoff object to it, given his outrage over the fact that the civil fine in the original settlement was to be borne by the victims of the alleged “lies” (Judge Rakoff’s words) — BofA’s shareholders?

On the other hand, as an astute colleague of mine has observed, how would the SEC look if it agreed to a settlement eliminating the fine agreed to by BofA? Better to try the case and let the judge decide upon the appropriate monetary remedy (and take whatever heat comes from doing so).

D. Will BofA Waive the Attorney-Client Privilege?

In my post of September 15, 2009, I speculated on this question, concluding that it is unlikely that the Bank would respond affirmatively to any Commission request that it waive the privilege so as to allow everyone to come clean on what was discussed between the Bank and its lawyers concerning the proxy statement’s disclosure of Merrill’s year-end bonuses.

In my initial post on this case of September 3, 2009, I speculated on the possible explanations for the proxy statement’s omission of the Bank’s agreement with Merrill that Merrill could pay up to $5.8 billion in year-end bonuses, ranging from a deliberate omission to the explanation that it was simply an inadvertent omission, due to the incredible time pressures under which this deal and the proxy statement were cobbled together. If I am correct, why not waive the privilege and frankly admit that yes, the agreement set forth in the disclosure schedule was not included in the proxy statement, the explanation being that the team responsible for preparing the disclosure schedule did not adequately communicate with the team drafting the proxy statement — the failure was therefore simply a boot?

The problem with waiving the privilege, however, is that it can have other consequences, including in related litigation. And if BofA waived the privilege here, how could it avoid doing so in any future litigation or dispute? Moreover, the SEC has made clear that the record to date does not provide any evidence of the requisite scienter to enable the SEC to name as party defendants any officer of BofA or its counsel, so why not let a sleeping dog lie?

E. And Now for Judge Rakoff

What remedies would he impose upon BofA if it is found liable for having violated the proxy rules?

Judge Rakoff as judge has to be a neutral arbiter. He cannot force the SEC to name defendants, develop theories of liability, or examine witnesses (as a litigant). So let’s assume the Commission tries the case solely against the Bank, and Judge Rakoff (or a jury) finds the Bank liable for a proxy violation in failing to disclose its agreement with Merrill to allow Merrill to pay billions in-year 2008 bonuses. What sanctions does Judge Rakoff then impose upon the Bank?

The Commission in its complaint seeks monetary damages against the Bank pursuant to the provisions of Section 21(d)(3) of the Exchange Act. The “money penalties” available to the Commission under this provision are a function of the “tier” in which a violation falls. Assuming the BofA finder of fact does not conclude that BofA committed an act of fraud, deceit, manipulation, or a deliberate or reckless disregard of the proxy rules, which appears to be the state of the record based upon what the SEC asserts in its briefs filed in support of the settlement, then the relevant tier to which any probable violation found against the Bank would fall is the “first” tier. For corporations, the amount of a first tier penalty is, for “each violation,” $50,000 or, if the defendant has realized “pecuniary gain,” then the gross amount of such gain.

How does one get to a penalty in the millions of dollars under such provision? One way is to find numerous violations, e.g., 50 different misleading statements in a proxy statement. The law in this area is unclear. One mechanism of truly expanding the penalty would be to find a separate violation based upon the number of shareholders to whom the BofA proxy statement was sent — which numbered 283,000. 283,000 times $50,000 is real money. But the point is that even if the Court finds the Bank to have violated the proxy rules, getting to a fine in the range of $33 million (the fine BofA agreed to pay in the settlement) takes some work. Given Judge Rakoff’s express concerns about the burden of any civil fine, it would be surprising if he imposed one of any material significance against the Bank.

How about an injunction, identical to the one secured by the SEC in its settlement? Here, the Bank will inevitably argue that the odds of its repeating a proxy violation are nil, and therefore even the imposition of an injunction is inappropriate. So, while the imposition of an injunction as a remedy for any finding of a proxy violation by the Bank would not surprising, there could be a real fight over even its appropriateness given relevant case law about the standards governing the entry of injunctions.

So it’s entirely possible that even if the Bank is found liable for proxy violations as alleged by the SEC, the remedies Judge Rakoff would enter will not be as stringent as those set out in the settlement to which BofA was prepared to accept. How will that look? And who would suffer if that were the case? If the answer is Judge Rakoff, then perhaps there are grounds for one or both of the parties to ask him to recuse himself from the case.

The twists and turns this case has taken are not yet over.

The Settlement in SEC v. Bank of America Corp: Judge Rakoff As Populist---Settlement Rejected

2009-09-15T14:58:00.000-07:00

While he telegraphed his displeasure with the settlement both at the hearing held on August 10, 2009 on the settlement and in his order requesting clarification of the parties’ initial submissions on August 25, Judge Rakoff’s rejection of the settlement by his order of yesterday was nevertheless surprising. As he himself admits, settlements of this nature, by an agency that is as generally respected by the courts as the SEC, are rarely set aside. This one has been, to the general acclaim of the populace, if the reactions in the press, ranging from The New York Times to The Wall Street Journal, are any indication. The comments on The Times’ website to its report of the settlement yesterday were overwhelmingly favorable. Here’s a sample, from some of the 385 readers’ comments (as of September 15) from The Times’ website:

“Thank you your Honor!”

“Such fundamental reasoning was sorely missing from all the prior bailout efforts.”

“Well, what do you know? A judge does the right thing.”

“Yes, there is justice in this world.”

“Good to see the light of Justice exposing and rejecting the ‘insider’ deal between the SEC and BOA!”

“I like this judge! Nominate him for Stevens’ seat on SCOTUS!”

“A judge with some intelligence and integrity. Faith renewed, at least temporarily….”

A. Judge Rakoff, Populist

The Judge’s September 14th order rejecting the settlement is a refreshing read. He disdains the technical language of securities lawyers, and says it plain and simple. Where the Commission refers to BofA’s proxy statement as containing a “proxy violation” and “false” and “misleading” statements, the Judge refers to BofA’s conduct as allegedly “lying” to its shareholders. Thus Judge Rakoff begins his order:

“In the Complaint in this case, … the Securities and Exchange Commission … alleges, in stark terms, that defendant Bank of America Corporation materially lied to its shareholders….”

What particularly frosts the Judge is that the effect of the settlement is to impose upon the victims of the Bank’s alleged lies — BofA’s shareholders — the burden of paying the settlement’s fine of $33 million:

“In other words, the parties were proposing [by the settlement] that the management of Bank of America — having allegedly hidden from the Bank’s shareholders that as much as $5.8 billion of their money would be given as bonuses to the executives of Merrill who had run that company nearly into bankruptcy — would now settle the legal consequences of their lying by paying the S.E.C. $33 million more of the shareholders’ money.”

September 14th Order at 2.

The Judge blasts the settlement as none of “fair, nor reasonable, nor adequate.” Not content to rely solely on law and notions of justice, the Judge finds that the proposed settlement violates fundamental norms of morality:

“It is not fair, first and foremost, because it does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for that misconduct.”

September 14th Order at 4.

Not the prose one typically reads in legal opinions!

In response to the SEC’s argument that the penalty against the corporate entity — the Bank — is justified because it would send “a strong signal to shareholders that unsatisfactory corporate conduct has occurred [and would allow] shareholders to better assess the quality and performance of management,” the Judge is aghast:

“This hypothesis, however, makes no sense when applied to the facts here: for the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion-dollar purchase of a huge, nearly-bankrupt company, need to lose another $33 million of their money in order to ‘better assess the quality and performance of management’ is absurd.”

September 14th Order at 4.

And in response to the Bank’s claims that its investigation indicated that it was the Bank’s lawyers who drafted the proxy statement, the Judge offers the obvious rejoinder: “But if that is the case, why are penalties not then sought from the lawyers?” Id. at 5.

The Judge blasts BofA for, on the one hand, claiming its innocence of the charges of distributing a misleading proxy statement while at the same time agreeing to fork over $33 million of its shareholders’ money. Not only does the Judge question the decision as a business matter, but he points to the obvious, namely, that management of the Bank may not be disinterested parties:

“It is one thing for management to exercise its business judgment to determine how much of its shareholders money should be used to settle a case brought by former shareholders or third parties. It is quite something else for the very management that is accused of having lied to its shareholders to determine how much of those victims’ money should be used to make the case against the management go away.”

September 14th Order at 7 (footnote omitted).

In what must particularly sting the Commission, particularly under its new head Mary Schapiro, the Judge characterizes the settlement at a “contrivance” designed to provide cover to the SEC:

“Overall, indeed, the parties’ submissions, when carefully read, leave the distinct impression that the proposed Consent Judgment was a contrivance designed to provide the S.E.C. with the façade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry — all at the expense of the sole alleged victims, the shareholders.”

Id. at 8.

In a final call to arms, the Judge throws down the gauntlet:

“Yet the truth may still emerge. The Bank of America states unequivocally that if the Court disapproves the Consent Judgment, it is prepared to litigate the charges. … The S.E.C., having brought the charges, presumably is not about to drop them. Accordingly, the Court, having hereby disapproved the Consent Judgment, directs the parties to file with the Court, no later than one week from today, a jointly proposed Case Management Plan that will have this case ready to be tried on February 1, 2010.”

Id. at 12 (footnote omitted).

B. Now What?

The first question for the parties is whether to appeal Judge Rakoff’s rejection of their settlement. (Not being a litigator, I assume each can do so.) While the Judge’s comments undoubtedly rub both parties raw, I assume cooler heads will prevail and one or both of the SEC and the Bank will appeal. From the SEC’s standpoint, none of the arguments it advanced to Judge Rakoff for approving the settlement go away. The Judge’s comments about the burden of the $33 million fine being borne by the innocent shareholders of BofA will hurt, because they are true, but I doubt the SEC is ready to forego its policy of imposing corporate fines altogether. Plus the Commission has its institutional prerogatives to protect, namely, its discretion in investigating, prosecuting, and settling cases. Plus Judge Rakoff is known as a maverick, so the Commission will undoubtedly assume it would receive a more receptive audience at the Second Circuit.

From the Bank’s standpoint, before pursuing any appeal it will have to swallow the bravado of its briefs that if the case were tried, the Bank would undoubtedly prevail. The Bank would be foolish to submit to Judge Rakoff and/or to a jury a case involving, at its core, the payment of billions of dollars in bonuses to Wall Street executives. Testifying in court and before a jury of your average New Yorkers is not something Ken Lewis and the other executives of the Bank will relish. So I would expect the Bank to conclude that a deal is a deal and that this deal should be approved.

If, surprise of surprises, the case does head to trial, then one of the first issues the parties will have to address is the Bank’s invocation of the attorney-client privilege. Fundamental to the Commission’s defense of the settlement and its failure to include any individual officers of BofA is the fact that the Bank invoked the privilege, thereby preventing the Commission from investigating communications between the Bank and counsel regarding the proxy statement’s disclosures concerning the payment of discretionary year-end bonuses to Merrill’s executives and employees. Somewhat surprisingly, the Bank, in its reply memorandum of September 9, 2009, appears to take the position that it did not invoke the attorney-client privilege: “It [the Bank] did not prevent any witnesses from testifying or ever invoke the attorney-client privilege in testimony regarding the subject of whether or how to disclose Merrill Lynch’s incentive compensation.” Reply Memo at 1. While this statement is hedged, undoubtedly the first question the Commission would put to the Bank, if the parties proceed to trial, is whether the Bank will now waive the privilege as to all communications between the Bank and counsel regarding the disclosures in the proxy statement concerning bonus compensation to Merrill’s officers and employees. While the Bank may squirm at that question, I would anticipate the response would be a firm “No.”

If the case proceeds to trial, would the Commission add as party defendants any officers of the Bank? Any lawyers of its counsel, the Wachtell firm? It would seem, given a trial date of February 1, 2010, that it is a bit late to add party defendants. Moreover, the Commission has made plain in its briefs filed with the Court that it was not able to develop any evidence establishing scienter on behalf of the Bank’s officers or counsel, and so, how could it name any such individuals as party defendants now?

And, if the case proceeds to trial, and the Commission does not add to the case any individual party defendants, what is the point of proceeding? It would appear that hell will freeze over before Judge Rakoff would impose a penalty on the Bank when no individuals stand before him as defendants, so what would the Commission seek in any trial against the Bank only?

So, upon reflection, the odds of the parties taking up Judge Rakoff’s command to proceed to trial appear nil. Next up: the Second Circuit.

The Settlement in SEC v. Bank of America Corp. Under Attack: Bank of America's Defense of the Settlement

2009-09-09T16:43:00.000-07:00

In my post of September 3, 2009, I addressed the settlement entered into on August 3, 2009 between the SEC and Bank of America in which the Bank, settling the SEC’s complaint of the same day alleging material misstatements and omissions in the Bank’s October 31, 2008 proxy statement, agreed to a permanent injunction against future violations of the proxy rules and agreed to pay a $33 million fine. I reviewed the SEC’s support of the settlement and Judge Raikoff’s concerns over the settlement. In this post I discuss the Bank’s defense of the settlement, set forth in its memorandum filed August 24, and the submissions of its two experts, Morton Pierce, chairman of Dewey & LeBoeuf’s mergers and acquisitions group, and Joe Grundfest, professor of law at Stanford.

A. The Best Defense is a Powerful Offense

It is clear that what bothers Judge Raikoff about the settlement is the SEC’s failure to name, and include in the settlement, any of the Bank’s officers. In its defense of the settlement, the Bank chooses not to defend this specific omission, but to assert that the SEC’s complaint itself is subject to powerful defenses and that, if the case were tried, the Bank would likely prevail. The thrust of the Bank’s position, therefore, is that the settlement should be approved because the SEC is fortunate to have secured the terms that it did — never mind that one or more individual officers of the Bank was not named as a defendant in the SEC’s complaint.

In support of its position, the Bank makes two arguments: first, that its proxy statement contained no false or misleading statement and no material omission, and second, that even if the proxy statement can be faulted for not specifically flagging Merrill’s and the Bank’s agreement that Merrill could pay year-end incentive bonuses of up to $5.8 billion, the omission was immaterial, given that Merrill’s intent to pay year-end bonuses in approximately this amount was well known to the market prior to the stockholder vote on the merger, via Merrill’s SEC filings and in extensive press reports concerning Merrill.

B. No Misstatement or Omission

The crux of the SEC’s complaint against BofA is that the Bank failed to disclose in the proxy statement distributed to the Bank’s stockholders in connection with the Merrill merger its agreement with Merrill that Merrill could pay up to $5.8 billion in discretionary year-end performance bonuses to Merrill’s officers and employees. In the merger agreement, summarized in the joint proxy statement, the Bank and Merrill agreed that Merrill would not pay discretionary bonuses to its directors, officers, and employees between the date of the merger agreement (September 15, 2008) and the close of the merger, except as set forth in Merrill’s disclosure schedule, without the prior written consent of the Bank. The disclosure schedule, which was not filed with the merger agreement or otherwise made publicly available, reflected the parties’ understanding and agreement that Merrill could pay discretionary year-end bonuses in an amount not to exceed $5.8 billion in the aggregate (and $4.5 billion in the aggregate as an accounting expense).

In defending the proxy statement disclosure, the Bank distorts what the SEC alleges in its complaint, asserting that the Commission alleges that Merrill “was prohibited from making [year-end] bonus payments.” Bank’s Memorandum of August 24, 2009 (“BofA Memo”), at 1. The charge is picked up by Professor Grundfest in his affidavit in support of the Bank’s submission: “The Complaint alleges that Bank of America made ‘representations that Merrill was prohibited from making [year-end bonus] payments.’” Grundfest Affidavit, dated August 21, 2009, ¶ 34. But it wasn’t Merrill’s negative covenant not to pay year-end discretionary bonuses that the Commission attacked, but the proxy statement’s failure to disclose the deal that the Bank and Merrill had already struck by the time they signed the merger agreement:

“The omission of Bank of America’s agreement authorizing Merrill to pay discretionary year-end bonuses made the statements to the contrary in the joint proxy statement and its several subsequent amendments materially false and misleading. Bank of America’s representations that Merrill was prohibited from making such payments were materially false and misleading because the contractual prohibition on such payments was nullified by the undisclosed contractual provision expressly permitting them.”

SEC Complaint, dated August 3, 2009, ¶ 3.

Morton Pierce, one of the Bank’s experts, testifies in his affidavit that the inclusion of compensation-related information in disclosure statements and the non-disclosure of the contents of disclosure statements is customary practice in M&A transactions. That may very well be true, but it does not respond to the question of whether non-disclosure of BofA’s and Merrill’s agreement on the payment of year-end bonuses in this disclosure statement made the Bank’s statement in its proxy statement that no such bonuses would be paid without the Bank’s written consent misleading. (And, on that point, Mr. Pierce is careful to “express no view.”). And, while maintaining the confidentiality of disclosure statement disclosures is customary, neither the Bank nor its experts respond to the point, made by the SEC in its August 24th memorandum, that the very Reg. S-K instructions that permit the nondisclosure of disclosure statements requires disclosure of their contents if “such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document [transmitted to the shareholders and/or investors].” Reg. S-K, Item 601(b)(2).

So I don’t find persuasive the Bank’s claim that its proxy statement disclosure concerning its agreement with Merrill over the payment of discretionary year-end bonuses is not misleading.

C. The Omission of the Agreement on Payment of Year-End Bonuses Was Immaterial

The Bank has a stronger argument on this point. The Bank does not claim that the amount of the permitted year-end bonuses — up to $5.8 billion — is not material, but that the fact and probable amount of Merrill’s intent to pay such bonuses was widely known, both through Merrill’s 10-Q filings with the SEC and in press reports. The Bank cites Merrill’s first two 2008 quarterly reports for the proposition that Merrill had made known to the market its intent to pay compensation and bonuses in an amount comparable to those paid in 2007, and continued with that disclosure in its 10-Q filed after announcement of the merger agreement on September 15, 2008 (for the third calendar quarter ended September 30, 2008). And the Bank, primarily through Professor Grundfest, cites, ad nauseum, media reports that detailed Merrill’s claims to pay compensation and bonuses, including reports from The New York Times, Bloomberg News, and The Today Show, to the effect that Merrill was setting aside some $6.7 billion for officer and employee bonuses.

Both the Bank and Merrill, in their joint proxy statement, as is typical, incorporated by reference their recent SEC filings, including their 2008 10-Qs, and the SEC filings they would make prior to the stockholder meeting of December 5, 2008. So the Bank could clearly raise as a defense that the very information the Commission alleges it omitted from its proxy statement could be found in the Bank’s SEC filings. While media reports are not incorporated by reference in SEC filings, the Bank could argue that the information on Merrill’s expected bonuses was so widely available that the “market” and therefore BofA’s stockholders must be considered to have been aware of it.

The SEC, in its initial August 24 filing, anticipated these claims, and responded by pointing out that Merrill’s SEC filings do not break out bonuses from compensation accruals generally, and that BofA’s stockholders should not be expected to conduct a treasure hunt to ascertain information material to their vote on whether to approve the Bank’s merger with Merrill:

“Although tidbits of information relevant to the issue of year-end compensation at Merrill were available to the public at the time that the proxy materials were disseminated, none of that information disclosed Merrill’s plan to pay billions of dollars in discretionary bonuses and, more importantly, Bank of America’s consent to that plan in connection with the proposed merger. Merrill’s quarterly filings disclosing accruals for “compensation and benefits” did not provide any breakdown for the components of that aggregate accrual. An investor could not have known what portion was being accrued for year-end bonuses as opposed to salaries, benefits, or other expenses. In any event, investors are entitled to full disclosure of material facts within the four corners of the proxy statement and are not required to puzzle through reams of other data from which they may or may not be able to infer those material facts. ….

"While Merrill’s plan to pay bonuses was discussed to some extent in the media before the December 5, 2008 shareholders’ meetings, these reports do not negate Bank of America’s liability for its misleading proxy statement. As an initial matter, the media reports consisted of speculation and some of the reports were based on anonymous sources. Moreover, none of the reports stated that Bank of America had contractually consented to the payment of the Merrill bonuses before the merger closed. In any event, investors were not required to ignore Bank of America’s express representations in its proxy materials and rely instead on sporadic media speculation that was inconsistent with those representations.”

SEC August 24 Memo at 22-23 (emphasis in original).

The Bank’s reliance upon the claim that Merrill’s intent to pay year-end bonuses in the range of $5.8 billion (the actual bonuses paid were some $3.6 billion) was so widely known as to make the failure to expressly refer to that intent in the proxy statement immaterial raises an obvious question: if so widely known, why not include the Bank’s agreement with Merrill that it could pay bonuses of up to $5.8 billion in the proxy statement? Why the need to maintain in confidence information that was known, among others, by the viewers of The Today Show?

The Bank’s claim that the omission of its agreement with Merrill over the payment of year-end bonuses from the text of the proxy statement was immaterial should give Judge Raikoff pause, and could very well establish the bona fides of the settlement to his satisfaction. But if not, and the tone of his August 25 Order reflects considerable skepticism about the merits of the settlement, then the Bank will be forced to emphasize that while it may have exposure for the omission, none of its officers should have as there is no evidence that any of them had the slightest awareness of the omission and therefore no evidence to establish the necessary scienter that would have justified the SEC’s naming any of the Bank’s officers as defendants in the complaint.

The parties have today filed their replies, including to the issues raised in Judge Rakoff's August 25th order. I will address any points I find of interest in their briefs in a subsequent post.

The Settlement in SEC v. Bank of America Under Attack: Judge Rakoff v. the Attorney-Client Privilege

2009-09-03T13:20:00.000-07:00

The SEC and Bank of America confronted a skeptical audience in the form of Judge Rakoff when they presented to him their settlement for approval on August 10, 2009. The Judge asked for further background on the settlement by written submissions (filed on August 24, 2009), which are to be followed by further written submissions (each party responding to the other’s initial submissions) on September 9, 2009. Following the initial submissions on August 24, the Judge issued an order the following day, requesting responses to questions he had that were prompted by the initial submissions.

The Commission filed its complaint and announced its settlement with BofA on the same day — August 3, 2009. The complaint names the Bank only, asserting that, by its October 31, 2008 proxy statement distributed to its stockholders in connection with the Bank’s proposed merger with Merrill Lynch & Co., Inc., the Bank had made materially false and misleading statements concerning its agreement with Merrill for the payment of year-end discretionary bonuses to Merrill’s officers and employees. By the settlement, the Bank agreed to a permanent injunction from violating Section 14(a) of the Exchange Act and the SEC’s Rule 14a-9 (both governing proxy statements), and agreed to pay a penalty of $33 million.

What clearly is troubling the Judge is the SEC’s failure to name in its complaint any of the Bank’s officers. As the Judge observes in his August 25th follow-up order, the burden of the payment of the penalty of $33 million will fall upon the stockholders of BofA (and possibly U.S. taxpayers, given the $45 billion that the Government has invested in the Bank and Merrill). And yet, observed the Judge, “the gravamen of the violation asserted in the [SEC’s August 3d] Complaint is that Bank of America, through its management, effectively lied to its own shareholders.” August 25th Order at 2. Quoting from the SEC’s own guidelines concerning the imposition of financial penalties, the Judge noted that the SEC’s historical position is that:

“Where shareholders have been victimized by the violative conduct, or by the resulting negative effect on the entity following its discovery, the Commission is expected to seek penalties from culpable individual offenders acting for the corporation.”

Id.
So why did the Commission not name Ken Lewis (BofA’s CEO) or any of the other senior officers of the Bank for the alleged false statements in the Bank’s proxy statement?

A. The Alleged False Statements

As is typical, the BofA/Merrill merger agreement contains a series of restrictions on the conduct of Merrill’s business between the date of signing (September 15, 2008) and the close of the merger. These restrictions, referred to as “forbearances,” numbered some 18 in the BofA/Merrill merger agreement. The section containing the forbearances (§ 5.2) is prefaced by this qualification: “… except as set forth in this [sic] Section 5.2 of the Company Disclosure Schedule …, [the] Company shall not … without the prior written consent of [BofA]….” The disclosure schedule, as is customary, is not attached to the merger agreement that was distributed to BofA’s stockholders or otherwise made publicly available, and was not filed with the SEC.

One of the “forbearances” Merrill agreed to was that it would not pay any discretionary bonuses to its directors, officers, or employees. However, in the disclosure schedule Merrill disclosed, and BofA thereby consented to, the payment of discretionary bonuses for 2008 to Merrill’s officers and employees in an amount not to exceed $5.8 billion (further limited to an amount not to exceed an accounting expense of $4.5 billion (the difference due to timing differences required under GAAP)).

The proxy statement, in describing the terms of the merger agreement (ad nauseum), repeats the language of the merger agreement in its description of the “forbearances” agreed to by Merrill, but also does not disclose the contents of the disclosure schedule reflecting the parties’ understanding and agreement to the payment of bonuses not to exceed $5.8 billion.
This discrepancy constitutes the nub of the SEC’s complaint against BofA, as summarized by the Commission in its August 24th filing with the Court:

“Bank of America’s statement was materially false and misleading because it indicated to shareholders that Merrill would only make ‘required’ payments to its employees, such as salary and benefits, but would not pay discretionary year-end bonuses. In fact, Bank of America expressly had agreed to allow Merrill to pay up to $5.8 billion in discretionary year-end bonuses. A shareholder could not have known from reading the proxy statement that Bank of America had already authorized Merrill to do precisely that which the proxy statement indicated Merrill could not do, i.e., pay discretionary year-end bonuses. The statements in the merger agreement regarding the non-payment of bonuses were thus false and misleading without the information set forth in the omitted disclosure schedule.”

Commission’s Memorandum of August 24, 2009 (“SEC Memo”), at 20.

In support of the materiality of the Bank’s failure to disclose its agreement for the payment of up to $5.8 billion in year-end discretionary bonuses to Merrill’s employees, the Commission points to the fact that the $5.8 billion constituted nearly 12% of the $50 billion that the Bank agreed to pay to acquire Merrill and 30% of Merrill’s total stockholders’ equity. SEC Memo at 22.

B. How to Explain the Discrepancy Between the Negative Covenant on the Payment of Bonuses and the Agreement Reflected in the Disclosure Schedule

What was BofA’s explanation for the discrepancy? Answer: No answer.

“Lewis, Thain [Merrill’s CEO] and Fleming [Merrill’s President] were all asked by Commission staff why this information was set forth in a disclosure schedule as opposed to the text of the merger agreement itself, but none of them could provide an answer. According to Lewis, Thain, Fleming, Curl [BofA’s Vice Chairman for Corporate Planning and Strategy] and Stingi [BofA’s Global Head of Human Resources] that issue was determined by lawyers at Wachtell [BofA’s counsel], Shearman [Merrill’s counsel] and one or more of several lawyers who worked in Bank of America’s in-house legal department, ….”

SEC Memo at 11.

So why did the lawyers from these two distinguished firms (Wachtell and Shearman) not disclose the agreement as to the payment of year-end bonuses in the proxy statement? What discussions, if any, were held between the lawyers and BofA concerning such a disclosure? We don’t know because BofA asserted the attorney-client privilege with respect to all communications with counsel, and the Commission was powerless to compel the Bank to waive the attorney-client privilege in connection with its investigation:

“The evidence obtained by the Commission in its investigation established that the determination of whether to include the ‘disclosure’ schedule in the proxy statement or otherwise to disclose that Bank of America had authorized Merrill to pay up to $5.8 billion in year-end bonuses was either made by, or at least based on the advice of, in-house and outside counsel for Bank of America and Merrill. All the relevant witnesses stated that the written merger agreement, the ‘disclosure’ schedule, and the proxy statement were negotiated and prepared by counsel for the two companies. The witnesses also stated that they relied entirely on counsel to decide what was or was not disclosed in the proxy statement. The Commission found no evidence to the contrary. Nor did the Commission find any evidence of internal deliberations or discussions, aside from consultations with in-house counsel, concerning the disclosures at issue in this case. Bank of America has not waived the attorney-client privilege. As a result, the investigative record does not include any specific rationale as to why the disclosure schedule or its contents were not disclosed in the proxy statement.”

SEC Memo at 24-25 (footnote omitted).

C. The Use and Misuse of Disclosure Schedules

Disclosure schedules are critical in M&A transactions, as they are used to disclose exceptions and qualifications to a party’s representations and warranties. They are prepared with care because they protect a party from claims of breach of representations and warranties that are typically broad and unqualified. While the SEC’s disclosure rules require the filing of merger and like agreements, the rules permit the omission of disclosure schedules from filings made with the SEC, although with a caveat often overlooked:

“Schedules (or similar attachments) to these exhibits [merger agreements and the like] shall not be filed [with the SEC] unless such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document.”

Regulation S-K, Item 601(b)(2).

Regulation S-K further requires that the merger agreement that is filed contain a list “briefly” identifying the contents of all omitted schedules, together with an agreement to furnish supplementally a copy of the omitted schedule to the Commission upon its request.

Because schedules to merger agreements need not be filed with the Commission, it is tempting for parties to include in them information not strictly qualifying reps and warranties, side deals, and other miscellany. This case highlights one such example.

D. What Explains the Failure to Disclose the Agreement on Bonuses Set Forth in the Disclosure Schedule?

The short answer is that we don’t know, given the cloak of secrecy thrown over the question by BofA’s assertion of the attorney-client privilege. There are at least three possibilities:

(i) The parties, concerned over the reaction by BofA’s stockholders to any disclosure of the agreement on payment of year-end bonuses, deliberately buried their agreement on the payment of bonuses in the disclosure schedule;

(ii) The parties did not consider the agreement material and therefore concluded that no disclosure of it was necessary; or

(iii) The failure to disclose the agreement was a boot.

Given the nature of these parties and the competence and sophistication of their advisors, I regard the first possibility as remote, the second as unlikely, and the third entirely possible.

The context here is important. This deal, even by Wall Street standards, was a sprint. It was negotiated over a weekend, September 13-14, 2008, in the wake of Lehman Brothers’ rumored bankruptcy earlier that week, and inked on Monday, September 15. One can only imagine the intensity of the negotiations and the amount of work and coordination necessary to negotiate and draft the merger agreement and prepare the disclosure schedule. It would not be a surprise if the team in charge of the disclosure schedule was different from the team responsible for drafting the merger agreement and the team responsible for preparing the proxy statement. Mistakes in such a pressure cooker do happen.

E. Judge Rakoff’s Reaction to the Commission’s Explanation of Its Omission of Any Individuals from Its Complaint

Incredulity:

“This is puzzling. If the responsible officers of the Bank of America, in sworn testimony to the SEC, all stated that ‘they relied entirely on counsel,’ this would seem to be either a flat waiver of privilege or, if privilege is maintained, then entitled to no weight whatever, since the statement cannot be tested. …

"If the SEC is right in this assertion, it would seem that all a corporate officer who has produced a false proxy statement need offer by way of defense is that he or she relied on counsel, and, if the company does not waive the privilege, the assertion will never be tested, and the culpability of both the corporate officer and the company counsel will remain beyond scrutiny. This seems so at war with common sense that the Court will need to be shown more than a single, distinguishable case [John Doe v. United States, 350 F. 3d 299 (2d Cir. 2003)] to be convinced that it is, indeed, the law. It also leaves open the question of whether, if it was actually the lawyers who made the decisions that resulted in a false proxy statement, they should be held legally responsible.”

August 25th Order at 3-4.

The Judge’s puzzlement is understandable, but I think the SEC got it right, as long as we have an attorney-client privilege. The BofA officers who were involved in the negotiations with Merrill and the supervision of the documentation all testified, according to the SEC, that they could not explain why the agreement on bonuses set out on the disclosure schedule was not included in the merger agreement itself or in the proxy statement. And, as the Commission points out in its August 24th brief, the Commission found no other evidence associating any representative of BofA (other than counsel) with the proxy statement’s disclosures concerning the payment of bonuses. Given that proxy statements are not signed by any representative of the issuer (unlike registration statements), the Commission had to find some evidence of scienter or culpable participation by an officer to the challenged disclosures in the proxy statement to pursue that individual for a disclosure violation. And, with respect to counsel, to establish “aiding and abetting” exposure, the Commission must also establish knowing participation in the alleged material misstatements or omissions. Given the attorney-client privilege, and the absence of any other evidence tying individuals to the misleading disclosures in the BofA proxy statement, the Commission simply did not have the firepower to go after the officers of BofA or its counsel. And, given the severe criticism the Government has received for its efforts post-Enron to curb defendants’ reliance upon the attorney-client privilege (see, e.g., United States v. Stein, 541 F.3d 130 (2d Cir. 2008) (indictments dismissed against former partners and employees of KPMG, LLP for the Government’s actions depriving defendants of their right to counsel), and S. 445, the Attorney-Client Protection Act of 2009, 111th Cong. 1st Sess.) it was simply not in the cards for the Commission to lean on BofA to waive the privilege as to its communications with counsel.

___________________
In support of the settlement, BofA, in its August 24th submission to the Court, mounts a vigorous defense of the settlement, primarily by arguing that the SEC was lucky it got what it did because if the case were tried, BofA could defeat the charges. I will discuss BofA’s arguments, and the points made by its two experts, in a subsequent post.

A Walk Down Memory Lane: Macmillan 20 Years Later

2009-07-22T15:55:00.000-07:00

One of the seminal Delaware decisions from the hectic takeover decade of the 1980s is Mills Acquisition Co. v. Macmillan, Inc., decided 20 years ago, 559 A. 2d 1261 (Del. 1989) (the lower court decision, by Vice Chancellor Jacobs, is reported at 1988 WL 108332, 14 Del. J. Corp. L. 772 (Del. Ch. 1988)). The decision makes for fascinating reading. The practices followed by the Macmillan board and its advisors strike one as prehistoric by today’s standards.

Macmillan’s ineptitude certainly cannot be attributed to any lack of competent advisors, as it and its adversaries retained the best and the brightest: Macmillan retained First Boston and then its notable spinoff, Wasserstein Perella (Bruce Wasserstein); the Special Committee of Macmillan’s board retained Lazard Freres & Co. (Steven Golub) and, as its special counsel, the Wachtell firm. So Macmillan’s wayward behavior cannot be attributed to the quality of its advisors but to its domination by a determined CEO and perhaps to the lack of clarity in the applicable corporate governance standards of that time.

A. The Context

Macmillan was a large publishing, educational and informational services company. The Delaware Supreme Court’s decision in Macmillan was the culmination of a determined effort by Edward P. Evans, Macmillan’s Chairman and CEO, to avoid takeover attempts first by Robert M. Bass and then by Robert Maxwell, both “stars” of many 1980s takeover contests. (Maxwell, a Rupert Murdoch rival, had a colorful career, as a youngster escaping the Nazis from Czechoslovakia, serving, with distinction, in the British Army and later as a member of England’s Parliament, and then building a media empire from England. He died in November 1991, at the age of 68, presumably from falling overboard from his luxury yacht off the Canary Islands. The official verdict was accidental drowning, although some commentators have surmised that he may have committed suicide, and others that he was murdered.)

B. Management’s Restructuring Plan

Even before Bass and Maxwell appeared on the scene, Evans had moved preemptively to assume control of Macmillan in 1987 in response to Maxwell’s hostile bid for a Macmillan competitor, Harcourt Brace Jovanovich. Evans developed a restructuring plan comparable to that adopted by HBJ that would have transferred control of Macmillan to him and his management team through the grant of options and restricted stock, the leveraging of Macmillan to pay a special dividend to its shareholders, the breakup of the company in two, and the issuance of two classes of stock, one to management with super voting rights. The restructuring plan was enjoined by Vice Chancellor Jacobs on July 14, 1988 in Robert M. Bass Group, Inc. v. Evans, 552 A. 2d 1227 (Del. Ch. 1988) (“Macmillan I”). Promptly thereafter, Evans and his management team pursued a management buyout of Macmillan (“Macmillan II”) that ultimately led to this decision of the Delaware Supreme Court, in which Evans and his team were dealt their second defeat. Among other notable features of the restructuring plan struck down by Vice Chancellor Jacobs were the following:

• The Macmillan board granted management several hundred thousand restricted Macmillan shares and stock options, to be exchanged for several million shares of the recapitalized company; and

• Macmillan’s ESOP would purchase, with funds borrowed from Macmillan, a large block of Macmillan shares, and the then-existing independent ESOP trustee (CitiBank) would be replaced by management designees, giving them control over all of the ESOP’s unallocated Macmillan shares.

The board also granted Evans and his management team generous golden parachute agreements, and adopted a poison pill, from which the ESOP was exempted.

In approving the restructuring plan, the Chancery Court found that the Macmillan board was dominated by Evans and his management team.

C. The Bass Group

Bass appeared on the scene in October 1997, acquiring 7.5% of Macmillan’s outstanding shares. Management inaccurately characterized Bass to the Macmillan board as a greenmailer. Vice Chancellor Jacobs concluded in Macmillan I that the factual data relied upon by management to criticize Bass was false. As Vice Chancellor Jacobs concluded:

“[t]here is … no evidence that Macmillan management made any effort to accurately inform the board of [the true] facts. On the present record, I must conclude (preliminarily) that management’s pejorative characterization of the Bass Group, even if honestly believed, served more to propagandize the board than to enlighten it.”

Macmillan I, 552 A. 2d at 1232.

In the course of implementing the restructuring plan (before it was enjoined in July 1988), the board, among other things, adopted the Macmillan Non-Employee Director Retirement Plan, which provided lifetime benefits to seven of the Macmillan directors (including three of the five members on its Special Committee considering the restructuring) equal to the director’s fees being paid at the time of termination. (The plan was later amended to pay such benefits to the surviving spouses of board members.)

Almost as an afterthought, management decided in February or March of 1988 to appoint a Special Committee of the board to evaluate the restructuring plan. The members of the Special Committee were hand-picked by Evans. The Special Committee was not actually formed until May 1988, after management had conducted intensive discussions and negotiations over the restructuring plan with the “Committee’s” investment bank, Lazard. Representatives of Lazard spent over 500 hours with management on the proposed restructuring before the Special Committee came into existence and retained Lazard.

The annual meeting of Macmillan shareholders was held May 18, 1988. The day before the meeting, the Bass Group offered a friendly deal for all of Macmillan, at $64 per share, in cash, in an offer left open for further negotiation. The offer was publicly disclosed by the Bass Group in an SEC filing, although it was not mentioned by management at the annual meeting of shareholders the following day.

The Bass Group’s offer was disclosed to the board following the annual meeting. It was at this meeting of the board that the Special Committee was selected (one of whose members never attended a single committee meeting). Evans presented the restructuring proposal to the Special Committee, but the Committee was not given any negotiating authority regarding the terms of the restructuring. The board deferred discussion of the Bass Group proposal.

The Special Committee met for the first time on May 24, 1988. Evans selected the Wachtell firm to represent the Committee. None of the members of the Special Committee had met with either Lazard or Wachtell before the meeting at which they were appointed as the Committee’s advisors, and the Committee was not advised of management’s extensive contact with Lazard on the restructuring proposal over the preceding months. The Committee directed Lazard to evaluate management’s restructuring plan, along with the Bass Group’s offer.

Evans subsequently directed another member of management to meet with the Bass Group, but the officer was directed to tell the Bass Group to go away. No further substantive negotiations were conducted between Macmillan and the Bass Group, and the Special Committee did not press for negotiations between Macmillan and the Bass Group.

The Special Committee met on May 28, 1988 to hear Lazard’s presentation on management’s restructuring plan. By this point Macmillan had hired its own financial advisor, Wasserstein Perella. (In the small world department, Bruce Wasserstein is now Chairman and CEO of Lazard (NYSE: LAZ).) The restructuring plan was valued at $64.15 per share, which Lazard advised the Committee was fair, notwithstanding its valuation of Macmillan at $72.57 per share. Lazard recommended rejection of the Bass Group’s $64 all-cash “fully-negotiable” offer, as “inadequate.” Wasserstein Perella valued management’s restructuring proposal at between $63 and $68 per share, and made the same recommendation as Lazard concerning the Bass offer.

The Special Committee recommended that the board adopt management’s restructuring proposal and reject the Bass offer. The Special Committee had not negotiated any aspect of the restructuring with management.

Following the public announcement of the restructuring, on May 31, 1988, the Bass Group made a second offer for all of Macmillan’s stock at $73 per share. Alternatively, the Bass Group proposed a restructuring similar to the restructuring approved by the Macmillan board, differing only in that it would offer $5.65 in cash per share more to the stockholders of Macmillan.

On June 7, 1988, at a joint meeting of the Special Committee and the Macmillan board, Lazard advised the board that the Bass Group’s $73 cash offer was inadequate, given its previous evaluation of Macmillan at between $72 and $80 per share. Wasserstein Perella agreed, and so the board again rejected the revised Bass offer and reaffirmed its approval of management’s restructuring plan.

As noted, on July 14, 1988, Vice Chancellor Jacobs preliminarily enjoined the management restructuring and held that both of the Bass offers were “clearly superior” to the restructuring proposal.

The following day, management set in motion a course of action that led to the opinion of the Delaware Supreme Court in Macmillan II.

D. A Management Buyout; Maxwell Enters the Fray

Once Vice Chancellor Jacobs opened the field for the Bass Group’s offer, management immediately pursued defensive measures to thwart it, focusing primarily on a management buyout sponsored by the granddaddy of all buyout firms, Kohlberg Kravis Roberts & Co. The effort was launched by Evans without prior consultation or approval by the Macmillan board. Evans and his COO, William Reilly, directed Macmillan’s financial advisors to pursue a possible sale of the company. As characterized by the Delaware Supreme Court, the process was motivated by two primary objectives:

• To repel any third-party suitors unacceptable to Evans and Reilly; and

• To transfer an enhanced equity position in a restructured Macmillan to Evans and his management group.

559 A. 2d at 1272.

On July 20, 1988, the Bass Group was eclipsed when Maxwell entered the scene, proposing to Evans a consensual merger in a buyout offer of $80 per share. Maxwell indicated he was prepared to retain Macmillan’s management.

Macmillan did not respond to Maxwell’s overture for five weeks. Instead, management accelerated its discussions with KKR over a management buyout, which included, after execution of a confidentiality agreement with KKR, the provision of substantial non-public financial and other information to KKR.

Maxwell was not prepared to wait, so, after three weeks, on August 12, 1988, he made an $80 per share, all-cash tender offer to Macmillan’s stockholders. That same day, Maxwell sent another letter to Evans confirming the making of the tender offer and reiterating his desire to reach a friendly accord with Macmillan. “Significantly,” observed the Delaware Supreme Court, “no Macmillan representative ever attempted to negotiate with Maxwell on any of these matters.” 559 A. 2d at 1272.

Notwithstanding their earlier opinions that management’s restructuring, which would have delivered $64.15 per share to the stockholders of Macmillan (as determined by Lazard) (in a combination of cash and debt securities) was fair to the Macmillan stockholders and that Macmillan had a maximum breakup value of $80 per share, both Wasserstein Perella and Lazard issued new opinions on August 25 that Maxwell’s $80 per share offer “was unfair and inadequate.” Id. at 1273. Accordingly, the Macmillan board rejected Maxwell’s offer.
Evans and Maxwell met on August 30, 1988. Evans informed Maxwell that “he was an unwelcome bidder for the whole company….” Id.

Management continued its negotiations with KKR, and committed to KKR, on September 6, 1988, to a management buyout in which they would, of course, participate, even though KKR had not yet disclosed to Evans and his group the amount of its bid! KKR did commit to making a firm offer by the end of the week — September 9, 1988. And so Evans instructed Macmillan’s financial advisors to notify all remaining interested parties, including Maxwell, that final bids for Macmillan were due by the afternoon of September 9. The day before the deadline, Evans informed Maxwell that management would recommend the KKR leveraged buyout to the Macmillan board, and that he, Evans, “would not consider Maxwell’s outstanding offer [of $80 per share] despite Maxwell’s stated claim that he would pay ‘top dollar’ for the entire company.” Id. Evans also informed Maxwell that “senior management” would leave the company if any bidder other than KKR prevailed over a management-sponsored buyout offer. Maxwell repeated his offer to negotiate the purchase price.

During this period of time, Macmillan continued to drag its feet on providing complete information to Maxwell, notwithstanding that it had already been provided to KKR.

By the deadline, September 9, 1998, Maxwell sent another letter to Evans offering to increase his all-cash bid for the company to $84 per share.

Notwithstanding the deadline, Macmillan’s representatives continued to negotiate overnight with KKR until its offer was reduced to writing the next day, September 10. KKR offered to acquire 94% of Macmillan’s shares through a complicated, highly-leveraged, two-tiered transaction, with a “face value” of $85 per share, payable in a mix of cash and subordinated debt securities. It included a requirement that Macmillan pay KKR’s expenses and an additional $29.3 million breakup fee if its deal were busted up by virtue of a higher bid for the company.

The Macmillan board then met to consider the two remaining offers — Maxwell’s and the KKR/management proposal — on September 10 and 11, 1988. The financial advisors opined that KKR’s offer was both higher than Maxwell’s bid and fair to Macmillan’s stockholders from a financial point of view. The board thereupon approved the KKR offer and agreed to recommend it to Macmillan’s shareholders. A public announcement of the acceptance soon followed.

But Maxwell was not done. On September 15, 1988, Maxwell announced that he was increasing his all-cash offer to $86.60 per share. In the light of this move, the Macmillan board withdrew its recommendation of the KKR offer, and instructed Macmillan’s investment advisors to attempt to solicit higher bids from Maxwell, KKR, and any others.

At this point, Wasserstein Perella took over the bidding process, notwithstanding that Lazard, not Wasserstein Perella, served as the Special Committee’s financial advisor. The remaining bidders were instructed that final bids were due by the close of business on September 26, 1988. By the deadline, Maxwell made an all-cash offer of $89 per share. KKR submitted another “blended” offer of $89.50 per share, consisting of $82 in cash and the balance in subordinated securities. KKR’s offer included three conditions designed to end the auction: (i) the imposition of a “no-shop” covenant, (ii) the grant to KKR of a lockup option to purchase eight Macmillan subsidiaries for $950 million, and (iii) the execution of a definitive merger agreement by noon the following day, September 27, 1988.

Given the closeness of the offers, and the nature of KKR’s offer, Macmillan’s advisors concluded it was a toss-up and that the auction should therefore continue.

Notwithstanding their obvious interest in the process, Macmillan’s financial advisors (the exact culprit is not identified) advised Evans and Reilly of the state of play, informing them of both bids. Evans promptly tipped KKR to Maxwell’s bid. In addition, Bruce Wasserstein varied his instructions as to the final round of bidding, impressing upon KKR (but not Maxwell) “the need to go as high as [KKR] could go” in terms of price, and discouraging a lockup or advising care in the character of any lockup KKR should propose. 559 A. 2d at 1275-1276.

Shortly before the deadline, KKR submitted a final revised offer with a face value of $90 per share, again conditioned, but with a revised lockup reduced to the grant of an option on four subsidiaries for a purchase price of $775 million.

Macmillan’s advisors negotiated overnight with both Maxwell and KKR over the terms of their merger agreements. No representative suggested to Maxwell that it increase its bid (from $89 per share). “On the other hand, for almost eight hours Macmillan and KKR negotiated to increase KKR’s offer.” Id. at 1277. KKR did so, by five cents (!), to $90.05, but KKR extracted concessions for the increase.

On the morning of September 27, 1988, the Macmillan board met to consider the competing bids. The meeting was chaired by Evans. Wasserstein spoke for the financial advisors. The board was assured that the advisors had run a level playing field for the two bidders. Evans did not disclose to the board that he had tipped KKR to Maxwell’s bid. Wasserstein, management’s financial advisor, opined that the KKR offer was the higher of the two bids. The Lazard representative concurred in Wasserstein’s assessment.

The Macmillan board accepted the KKR proposal, and granted KKR the lockup option.

Showing that he was not a quitter, Maxwell, on September 29, 1988, the very day that KKR filed documents with the SEC amending its tender offer to reflect the final deal, announced that he had amended his cash tender offer to $90.25 per share. But this was too late: the Macmillan board rejected it, and the focus turned to the litigation.

E. The Supreme Court’s Decision

It should come as no surprise that the Delaware Supreme Court came down like a ton of bricks on Macmillan and its advisors. The condemnatory language of the Court is as strong as one gets from what are normally staid jurists.

The Court begins with a statement of the relevant decisional framework:

“We have held that when a court reviews a board action, challenged as a breach of duty, it should decline to evaluate the wisdom and merits of a business decision unless sufficient facts are alleged with particularity, or the record otherwise demonstrates, that the decision was not the product of an informed, disinterested, and independent board. …. Yet, this judicial reluctance to assess the merits of a business decision ends in the face of illicit manipulation of a board’s deliberative process by self-interested corporate fiduciaries. Here, not only was there such deception, but the board’s own lack of oversight in structuring and directing the auction afforded management the opportunity to indulge in the misconduct which occurred. In such a context, the challenged transaction must withstand rigorous judicial scrutiny under the exacting standards of entire fairness. …. What occurred here cannot survive that analysis.”

559 A. 2d at 1279 (footnote and citations omitted).

The Court smoked Evans and Reilly, condemning their conduct as “resolutely intended to deliver the company to themselves in Macmillan I, and to their favored bidder, KKR, and thus to themselves, in Macmillan II.” Id. at 1279-1280. On the record, it is no surprise that the Court found the board to be “torpid, if not supine, in its efforts to establish a truly independent auction, free of Evans’ interference and access to confidential data.”

“By placing the entire process in the hands of Evans, through his own chosen financial advisors, with little or no board oversight, the board materially contributed to the unprincipled conduct of those upon whom it looked with a blind eye.”

Id. at 1280.

The Court condemned Macmillan’s conduct as failing “all basic standards of fairness.” Id. Indeed, one can catalog major errors made by the Macmillan board from the record, errors it is safe to say no competently counseled board of directors of a public company would make today:

• Macmillan’s management met with KKR to discuss a management-sponsored buyout, without prior notice to or approval of the Macmillan board;

• The Special Committee’s financial and legal advisors were chosen by management, not by the Special Committee of the board appointed to review management’s restructuring proposal and oversee the auction;

• The Special Committee delegated the creation and administration of the auction to Evans’ advisors, not to those of the Committee; and

• The Special Committee and the board as a whole conducted minimal oversight of the auction.

The integrity of the process becomes acute when insiders are among the bidders. The Court condemned the skewing of the process in favor of KKR:

“Clearly, this auction was clandestinely and impermissibly skewed in favor of KKR. The record amply demonstrates that KKR repeatedly received significant material advantages to the exclusion and detriment of Maxwell to stymie, rather than enhance, the bidding process.”

559 A. 2d at 1281.

Referring to its Revlon principles (decided in 1986), the Court emphasized that once the Macmillan board decided, in September 1988, to abandon further restructuring attempts and to sell the company, further “discriminatory treatment of a bidder, without any rational benefit to the shareholders, was unwarranted.” Id. at 1282. At that point in time, the Macmillan board’s obligation was to obtain the highest price reasonably available for the company, provided that it was offered by a “reputable and responsible bidder.”

Aside: This qualification is important, as the Court cites factors that a board may consider in evaluating a bidder, including

“… the adequacy and terms of the offer; its fairness and feasibility; the proposed or actual financing for the offer, and the consequences of that financing; questions of illegality; the impact of both the bid and the potential acquisition on other constituencies, provided that it bears some reasonable relationship to general shareholder interests; the risk of non-consummation; the basic stockholder interests at stake; the bidder’s identity, prior background and other business venture experiences; and the bidder’s business plans for the corporation and their effects on stockholder interests.”

559 A. 2d at 1282 n. 29.

The Court was apoplectic over Evans’ tip to KKR of Maxwell’s $89 all-cash offer following the first round of bidding, compounded by Evans’ and Reilly’s “knowing concealment of the tip at the critical board meeting of September 27,” conduct that “utterly destroys their credibility.” Id. at 1282. Indeed, the Court goes so far as to say that the tip and the failure to disclose it “was a fraud upon the [Macmillan] board.” Id. at 1283!

While the grant of a lockup is not a per se violation of a board’s fiduciary duties, and can play a function in a contest for corporate control, in this instance the Court concluded that the lockup granted to KKR “was not necessary to draw any other bidders into the contest.” Accordingly, the Court reversed the Chancery Court and sent the case back down with instructions to enjoin the lockup.
___________________

Macmillan is instructive in illustrating how far corporate practice has evolved in a relatively short period of time. Reading it today makes clear the shift in power over M&A transactions that has occurred in the past 20 years from management to the board and, within the board, to the independent directors. It is inconceivable that any M&A transaction involving a public company would be managed today as the change of control in Macmillan was “managed” in 1988.

Fiduciary Outs for Intervening Events: Are They Necessary?

2009-07-11T14:46:00.000-07:00

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.

The Battle for Data Domain; Has Data Domain Conceded the Application of Revlon to the Data Domain/NetApp Merger?

2009-06-26T15:04:00.000-07:00

In my post of June 24, 2009, I addressed the possible application of Revlon to the negotiations conducted by Data Domain with NetApp, concluding that it is likely that the application of Revlon to the negotiations will be vigorously contested by Data Domain and its board. I discuss herein whether Data Domain has conceded the issue by its response to the June 1, 2009 EMC announcement of its all-shares, all-cash $30 per share tender offer to Data Domain’s stockholders.

EMC announced its offer on June 1, 2009, and sent a letter to Data Domain’s CEO, Frank Slootman, the same day. The Data Domain board met to address the offer that very day, and concluded, after input from its counsel, Fenwick & West, and its banker, Qatalyst, “that EMC’s announcement of the EMC Offer was reasonably likely to lead to a Superior Proposal (as that term is defined in the Initial NetApp Merger Agreement).” Data Domain Schedule 14D-9, dated June 15, 2009, at 13.

The Data Domain/NetApp Merger Agreement contains a no-shop clause, subject to the right and power of the Data Domain board to respond to an unsolicited acquisition proposal as long as several conditions are met, including:

“(i) the Company Board shall have determined in good faith (after consultation with its financial advisor and its outside legal counsel) that (A) such Acquisition Proposal either constitutes or is reasonably likely to lead to a Superior Proposal and (B) the failure to take such action is reasonably likely to result in a breach of its fiduciary duties to the Company’s stockholders under Delaware Law; . . . .”

Merger Agreement § 6.1(c)(i) (emphasis added).

So the Data Domain board had to conclude not only that EMC’s $30 tender offer proposal constituted or was reasonably likely to lead to a “Superior Proposal,” but also that Data Domain’s failure to engage EMC over its offer would be “reasonably likely to result in a breach of its fiduciary duties to the Company’s stockholders under Delaware Law . . . .”

If Data Domain’s position will be that Revlon does not apply to their negotiations with NetApp, on the grounds that the deal was negotiated at arms-length and approved by a board of independent directors, is consistent with Data Domain’s strategic vision, and will not involve a change in control of Data Domain (by reason of the stock to be received in NetApp by Data Domain’s stockholders), à la Paramount Communications, Inc. v. Time Incorporated, 571 A.2d 1140 (Del. 1990), In re Santa Fe Pacific Corporation Shareholder Litigation, 669 A.2d 59 (Del. 1995), and Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270 (Del. 1994), then why did the Data Domain board conclude, after taking into account the advice of Fenwick & West, that failure to engage EMC over its proposed tender offer would be “reasonably likely to result in a breach of its fiduciary duties to the Company’s stockholders under Delaware Law”?

The Battle for Data Domain, Inc.: Postscript on Application of Revlon to Data Domain/NetApp Merger

2009-06-24T14:12:00.000-07:00

In my post of June 10, 2009, I critiqued the negotiations conducted by Data Domain with NetApp, leading to the May 20, 2009 announcement of the Data Domain/NetApp merger agreement, pursuant to which NetApp would acquire Data Domain’s by paying $25 per share in cash and stock (increased to $30 per share in cash and stock after EMC jumped into the fray on June 1, 2009 with its all-shares, all-cash tender offer of $30 per share).

In my critique of the Data Domain/NetApp negotiations, I was too quick to assume the application of Revlon duties (Revlon v. McAndrews & Forbes Holdings, Inc., 506 A. 2d 173 (Del. 1986)) to the negotiations, so I address the issue in this post.

A. When Revlon Duties Apply

When Revlon duties apply, it is the obligation of the board of directors to seek the highest value reasonably available to the stockholders. As I quoted from the Delaware Supreme Court’s recent decision in Lyondell:

“. . . directors must ‘engage actively in the sale process,’ and they must confirm that they have obtained the best available price either by conducting an auction, by conducting a market check, or by demonstrating ‘an impeccable knowledge of the market.’”

Lyondell Chemical Co. v. Ryan, 2009 WL 1024764 at *6 (footnotes omitted).

The reach of Revlon is not unlimited. It has historically been applied in three scenarios:

(i) When a company initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company; or

(ii) When, in response to a bidder’s offer, the company abandons its long-term strategy and seeks an alternative transaction involving the break-up of the company; or

(iii) When approval of a transaction results in a sale or change of control.

Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270, 1290 (Del. 1994) (citing Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1994) and Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1990)).

A Revlon change in control does not occur in stock for stock mergers where control of both companies remains in a large, fluid, changeable and changing market. Where there is no controlling or dominant shareholder of the acquiring company in a stock for stock merger, then Revlon is not applicable and the target directors’ decision, if made by independent directors, will not be subject to enhanced scrutiny but to the more director-friendly business judgment rule standard of review. Notable examples of this type of hands-off review in the context of stock-for-stock mergers are the Delaware Supreme Court decisions in Arnold and in Santa Fe Pacific Corporation Shareholder Litigation, 669 A.2d 59 (Del. 1995).

B. Revlon and the NetApp/Data Domain Merger

The shares of NetApp (NTAP) are broadly dispersed. Its largest stockholder, as reported in its proxy statement of March 23, 2009, is Wellington Company Management, holding a little over 10% of NetApp’s outstanding common shares. Wellington is a 13G filer, meaning that it holds its shares for investment, and not with any view to controlling NetApp or influencing its business.
As Chancellor Allen observed in Wells Fargo and Company v. First Interstate Bancorp, 1996 WL 32169 (Del. Ch. 1996), when Revlon duties apply, “the board must seek to achieve [the] greatest available current value; it may not, in effect, trade achievable current value for a prospect of greater future value, as it may normally do in the exercise of its good faith business judgment.” (Id. at *10 note 3.) Or, as Vice Chancellor Lamb observed in his decision in NCS Healthcare (reversed by the Delaware Supreme Court on other grounds), “[t]he record shows that, as a result of the proposed Genesis merger, NCS public stockholders will become stockholders in a company that has no controlling stockholder or group.” In re NCS Healthcare, Inc. Shareholders Litigation, 825 A.2d 240, 255 (Del. Ch. 2002).

The proposed Data Domain/NetApp merger involves both cash and NetApp stock, consisting of $16.45 in cash and from 0.7783 to 0.6370 in shares of NetApp common stock per Data Domain share of common stock, designed to deliver to the Data Domain stockholders an additional $13.55 in value. Thus, of the target consideration of $30 per share, 55% is proposed to be in cash and 45% in NetApp common stock.

So should the conduct of the board of directors of Data Domain be measured by Revlon or by the business judgment rule?

We should soon find out, as a complaint has now been filed in the Delaware Chancery Court challenging the proposed Data Domain/NetApp merger. The action has been brought by the Police & Fire Retirement System of the City of Detroit, as a purported class action, and clearly seeks to slot this merger in the Revlon category:

“Whatever doubt existed about the [Data Domain] Board’s duty to employ a reasoned process to maximize the price paid to shareholders was eliminated with the restructured NetApp deal. The Initial Transaction [at $25 per share] would cash out a significant portion of the Data Domain shareholders’ holdings. The Revised Transaction [at $30 per share], however, is indisputably a change in control because the majority of the consideration to be paid to shareholders is now cash. By agreeing to a transaction which results in the ‘cashing out’ of a majority of the shareholders’ prior equity positions, the [Data Domain] Board took on the obligation to maximize the price being paid.”

Complaint (No. 4663-VCL), dated June 12, 2009, ¶ 9.

There is some sense to granting a board more deference when it engages in a “strategic” merger involving stock for stock. It may make sense to merge with a young Google at a lesser price per share than a mature version 1.0 software company, even if the Google deal has a smaller value than that offered by the more mature suitor. And, while their reference to it appears pro forma, Data Domain and NetApp do cite the “strategic” benefits of their combination in their defense of the deal:

“• Synergy between NetApp and Data Domain. The Data Domain board of directors considered NetApp’s prospects following the closing of the merger. NetApp’s sales and distribution channels and international reach to [sic] offer the Data Domain product line to more customers, accelerating growth and market adoption. The Data Domain board of directors believed that the combination of the two companies would increase the value of NetApp and thereby the value of the NetApp common stock that Data Domain stockholders would receive in the merger.”

NetApp S-4, as amended June 23, 2009, at 37.

On the other hand, the carve-out from review under the Revlon standard for a stock-for-stock deal seems a bit artificial. If a suitor proposes an all-cash deal, the target should conduct a market check or satisfy itself in some other way that the price offered is the best price reasonably available. If the suitor, on the other hand, proposes an equity combination, then, under accepted Revlon jurisprudence, the target need not shop the company or do any other sort of market check. The distinction seems archaic, particularly where the initial suitor is amenable to doing a deal for cash or for cash and stock and/or competing suitors pound on the doors prior to the first deal being inked. And, if equity in the initial suitor is so attractive, why not accept a higher cash deal and let the stockholders decide for themselves whether to invest in the initial suitor (or one or more other companies)?

That a deal is subject to Revlon review does not mean that the board of directors is home free because, even in pure stock for stock deals, where a competing suitor is jilted, the Delaware courts have no hesitation in applying enhanced to scrutiny to the other measures adopted by the target board to protect the deal, such as a selective exemption under a poison pill, no-shop clauses, termination fees, the grant of lock-up options, and stockholder support agreements. And, of course, for the business judgment rule standard to apply in the first place, the “judgment” must be informed. In this deal, a real question arises as to how the Data Domain board of directors could, on an informed basis, enter into the NetApp deal without at least talking to EMC, given that EMC’s interest in doing a deal was made known to Data Domain before the NetApp deal was inked.

So, if the plaintiff in the Delaware action presses ahead for a preliminary injunction, it will be of interest to see how Vice Chancellor Lamb (to whom the case has been assigned) evaluates the conduct of the Data Domain board of directors — by Revlon, by the business judgment rule, or by enhanced scrutiny to the measures adopted by the Data Domain board to protect the NetApp deal.

In re Genentech, Inc. Shareholders Litigation; Settlement; Objection to Fee Request by Class Counsel

2009-06-19T10:22:00.000-07:00

I'm all in favor of generously compensating lawyers since I'm one, but the fee request of class counsel for plaintiffs in the Genectech/Roche litigation, for up to $24.5 million, strikes me as over the top. As a modest shareholder of Genentech I received notice of the settlement of the class actions (some 30 were filed the day of or shortly after Roche's initial announcement on July 20, 2008 of its intent to acquire the 45% of Genectech's shares it didn't own) and class counsels' application for an award of fees and expenses. The hearing will be held July 9, 2009, before Vice Chancellor Strine. Given Vice Chancellor Strine's close study of these types of fee requests--see his opus In re Cox Communications, Inc. Shareholders Litigation, 879 A.2d 604 (Del. Ch. 2005)--his reception of counsel's fee request will be closely watched.

I have commented on the fee application, and reprint my letter to the Court here (deleting information on my stockholding in Genentech):

"In response to the Notice of Pendency of Class Action, Proposed Class Action Determination, Proposed Settlement of Class Action, Settlement Hearing, and Right to Appear, dated May 4, 2009 (the “Notice”), I comment on one aspect of the Notice, plaintiffs’ counsels’ request for an award of up to $24,500,000 in attorneys’ fees and expenses, to be paid by Roche or Genentech. Based upon the history of the negotiations between Roche and Genentech, as laid out in Roche’s Offer to Purchase, as amended, and Genentech’s response, set forth in its Schedule 14D-9, as amended, an award of counsel fees of this magnitude would be excessive.

. . . .

A. Why Object at All?

Any award of attorneys’ fees made by the Court will be paid by Roche and/or Genentech. As a former shareholder of Genentech, I received cash for my shares. Accordingly, the economic burden of any award of counsel fees will not be borne by me (and I am not a shareholder of Roche). So what’s the point of objecting?

This question was addressed by Vice Chancellor Strine in his thorough consideration of a like fee application In re Cox Communications, Inc. Shareholders Litigation, 879 A.2d 604 (Del. Ch. 2005). The objectors to counsels’ fee application in that case likewise had no economic stake in any award of counsel fees. Nevertheless, the Vice Chancellor concluded that they did have standing to comment on the fee application:

“This is not to go to the other extreme and to say that the objectors have no standing to comment on the requested fee at all. They, of course, do. Stockholders have a cognizable interest in the integrity of the representative litigation process and in ensuring that it functions in a manner that generates benefits for its intended beneficiaries, and not windfalls to attorneys.”

Id. at 639.

B. What Benefits Did Counsel Achieve for Genentech’s Stockholders?

Where a fee award will not be borne by the plaintiff class, the factors to be considered in assessing a fee application are those listed in Sugarland Industries, Inc. v. Thomas, 428 A.2d 142 (Del. 1980). The first and most important factor, and the one I want to address here, are the “benefits achieved in the action.” Based upon the record of negotiations presented by Roche and Genentech, the benefits achieved by plaintiffs’ counsel were modest.

1. The Final Enhancement of Roche’s Offer from $93 to $95

The casual reader could be forgiven for concluding, based upon the background description in the Notice, that plaintiffs’ counsel played a significant role in the final enhancement of Roche’s offer from $93 to $95 a share (an increase that generated in excess of $1 Billion for the non-Roche shareholders of Genentech).

“After the Second Stipulation was approved [on March 11, 2009], during the late evening on March 11, 2009 and early morning on March 12, 2009, counsel to Roche and Co-Lead Counsel again discussed possible grounds on which to settle the Action. Co-Lead Counsel again expressed their view that the optimal outcome for Genentech’s stockholders was for Roche and Genentech to enter into a negotiated merger agreement, pursuant to which all Genentech stockholders would receive the same price per share. Co-Lead Counsel also expressed their view that Roche should increase its offer price from $93.00 per share. Co-Lead Counsel also indicated that, if Roche increased its offer to $95.00 per share, Co-Lead Counsel would support an amendment to the Affiliation Agreement to exclude such a merger from the Affiliation Agreement, so as to ensure that all Genentech stockholders would receive the same price per share, without affecting their appraisal rights under section 262 of the Delaware General Corporation Law.”

Notice at 7.

In their discussion of the settlement and their “participation in the settlement,” class counsel list, as one of the actions taken by Roche (impliedly at the behest of class counsel):

“G. During conversations with counsel to Roche during the late evening on March 11, 2009 and early morning on March 12, 2009, Co-Lead Counsel indicated that, if Roche increased its offer to $95.00 per share, Co-Lead Counsel would support an amendment to the Affiliation Agreement to exclude such a merger from the Affiliation Agreement, so as to ensure that all Genentech stockholders would receive the same price per share, without affecting their appraisal rights under section 262 of the Delaware General Corporation Law.”

Notice at 9.

But a review of the record as stated by Genentech and Roche paints a different picture. What broke the dam on this deal was Roche’s unilateral increase in its offer from $86.50 per share to $93.00 per share, announced on March 6, 2009. That significant increase in the offer price led Genentech’s Special Committee (headed by Dr. Sanders, Genentech’s Lead Director, and advised by Goldman Sachs and Latham & Watkins) to conclude it was time to cut a deal. And a deal quickly followed:

“On March 8, 2009, Drs. Sanders and Humer [Roche’s CEO] had a series of telephone conversations in which they discussed a price at which the Special Committee would recommend a transaction with Roche pursuant to a negotiated agreement. Dr. Sanders stated his belief that the Special Committee would be willing to support a transaction at a price in the high $90s. At the end of these conversations, Drs. Sanders and Humer agreed that Roche and the Special Committee would be prepared to enter into a transaction pursuant to which Roche would offer to acquire the Shares held by the Company’s public stockholders at a price of $95.00 per Share.”

Genentech’s Schedule 14D-9 (Amendment No. 5), dated March 12, 2009, at 6.

Roche’s description is more succinct:

“On March 8, 2009, Dr. Franz B. Humer, Chairman of Roche, received a call from Dr. Charles A. Sanders, Chairman of the Special Committee. They discussed a range of possible transaction prices and agreed to pursue negotiations concerning a transaction at $95 per Share.”

Roche’s Second Supplement to Offer to Purchase for Cash, dated March 12, 2009, at 7.

If Genentech’s and Roche’s recitations are to be believed, then Roche’s offer price was set at $95 per share on March 8, 2009, making counsel’s discussions with Roche’s counsel over price on March 11 and March 12 irrelevant to the final agreement. Plaintiff’s counsel, therefore, should be given no credit or “benefit” for the $95 per share offer price.

2. The Affiliation Agreement

Genentech and Roche were parties to an Affiliation Agreement, entered into in 1999. The Agreement imposed certain conditions upon any Genentech/Roche merger or like combination, including (i) that the transaction receive the favorable vote of a majority of the Genentech shares not held by Genentech, and (ii) in the event that such a favorable vote were not obtained (or no vote were required, such as in a short-form merger), then the consideration to be paid to the Genentech shareholders would “be equal to or greater than the average of the means of the ranges of fair values for the Shares as determined by two investment banks of nationally recognized standing appointed by a committee of independent directors.” Genentech’s Schedule 14D-9, dated February 23, 2009, at 2.

This provision created a speed bump for any Roche/Genentech short-form merger, both by reason of the delay that would be inherent in securing the bankers’ valuations, and because, theoretically, those valuations could be below or greater than the consideration paid by Roche for Genentech’s other shares pre short-form merger. Presumably (I have not reviewed the Affiliation Agreement), the Affiliation Agreement, being a two-party agreement, could be amended to remove this speed bump. And this is what the parties did, in order to provide speed and certainty as to the consideration payable to the Genentech shareholders in any short-form merger following Roche’s tender offer (and Genentech granted Roche a top-up option, at Roche’s insistence, to ensure that Roche got the 90% of Genentech’s shares after completion of its tender offer (assuming it were accepted by a majority of Genentech’s unaffiliated shareholders). As Genentech acknowledged in its March 12th Amendment to Schedule 14D-9, the amendment to the Affiliation Agreement did carry the risk of depriving the Genentech shareholders in any short-form merger of the possibility of a price higher than $95:

“While the Special Committee recognized that a non-tendering stockholder could potentially receive more than $93.00 per Share if Roche owned 90% or more of the Shares following consummation of the $93.00 Offer, it concluded that the higher price of $95.00 per Share and the certainty that it would be received by all of the public stockholders (assuming a majority of the Shares held by the company’s public stockholders were tendered into the Revised Offer) provided by the Merger Agreement was in the best interest of the Company’s stockholders, other than Roche and its affiliates.”

Id. at 8.

From the get-go, Roche promised, if it secured 90% or more of Genentech’s outstanding shares, to proceed to a short-form merger and pay the same offer price to the remaining Genentech shareholders that it offered to the other non-affiliated Genentech shareholders, “subject to compliance with the Affiliation Agreement between us and Genentech.” Roche Offer to Purchase for Cash, dated February 9, 2009, at 3.

Plaintiffs’ counsel’s objections to the Affiliation Agreement appear to be quibbles, namely, that the provision above quoted from the Affiliation Agreement could delay payment and did not provide assurance of the same price to the remaining stockholders as offered to the other Genentech stockholders. This was solved by the amendment agreed to by Roche and Genentech, an amendment clearly predictable once a deal was cut, given the sophistication of the Roche and Genentech advisors and their experience and competence in doing deals.

3. Other Purported Benefits

The other benefits achieved by plaintiffs’ counsel appear to be trivial or unnecessary. Thus, plaintiffs’ counsel secured in the First Stipulation acknowledgements from Genentech that it had either publicly stated or were noncontroversial, such as that the Affiliation Agreement and Genentech’s Certificate of Incorporation did not limit the Genentech board’s liability for breaches of the duty of loyalty (cf. Del. GCL § 102(b)(7)(i)), or that the Affiliation Agreement did not “eliminate or limit any statutory or common-law requirements for the consummation of a business combination involving Roche and Genentech; . . .” Notice at 5.

_________________________

Genentech’s board of directors, particularly the Special Committee, and the Special Committee’s advisors, demonstrated considerable skill and savvy in their negotiations with Roche. Through their efforts, the Roche Offer was increased from $86.50 per share to $95.00 per share. With respect to these negotiations, plaintiffs’ counsel played the role of sidewalk superintendents. For this role an award of $24,500,000, or anything approaching it, would be clearly excessive."

The Battle for Data Domain; A Critique of Data Domain's Negotiations With NetApp

2009-06-10T18:42:00.000-07:00

On May 20, 2009, Data Domain (NasdaqGS: DDUP) announced an agreement to merge with NetApp (NasdaqGS: NTAP) pursuant to which NetApp would acquire Data Domain’s outstanding common stock for $25 per share in cash and stock. EMC Corporation (“EMC”) (NYSE: EMC), which had been put off from participating in the negotiations for the sale of Data Domain, promptly reacted by announcing, on June 1, 2009, an all-shares, all-cash tender offer at $30 per share.

In response, NetApp, which had declared during its negotiations with Data Domain that it “would not engage in a bidding contest” for Data Domain if EMC or any other party were invited into the bidding process, promptly upped its bid to $30 per share, consisting of $16.45 in cash and from 0.7783 to 0.6370 shares of NetApp common stock, designed to deliver to the Data Domain shareholders an additional $13.55 in value (within a 10% collar ranging from $17.41 to $21.27 for NetApp’s common shares) (NetApp closed at $19.17 on June 10, 2009).

We are awaiting Data Domain’s response to the EMC tender offer, which is due by no later than June 16, 2009.

Given the way that the board of directors of Data Domain conducted the negotiations with NetApp, the board may be fortunate that EMC has now launched its tender offer for the outstanding shares of Data Domain. Defending the board’s actions in the face of any Revlon challenge might have been problematic.

A. Dancing with Only One Suitor

As is made clear in the background discussion of the merger in the proxy statement/prospectus filed by Data Domain and NetApp under cover of a Form S-4 filed with the SEC on June 4, 2009 (the “S-4”), Data Domain discussed a deal only with NetApp prior to entering into the merger agreement with NetApp on May 20, 2009. Discussions over a deal were held from time to time since 2006 between Data Domain’s President and CEO, Frank Slootman, and his counterpart at NetApp, Daniel J. Warmenhoven. Discussions turned serious in March of this year. Notwithstanding that it had served as a co-managing underwriter in Data Domain’s IPO in June 2007, Goldman Sachs represented NetApp in the negotiations, and sat in on the early discussions between NetApp and Data Domain, and before Data Domain had hired its financial advisor, Qatalyst Partners, on March 26, 2009, after at least two face-to-face meetings had been held between senior officers of NetApp and senior officers of Data Domain.

Undoubtedly with a view to its possible Revlon duties, Data Domain in its background discussion of the merger articulates early on its board’s justification for discussing a deal only with NetApp:

“The Data Domain board of directors expressed concerns regarding the potential harm to Data Domain’s business relating to any uncertainty perceived by its current or future customers should they learn of discussions regarding a potential business combination involving Data Domain and the ability of Data Domain’s competition to take advantage of any such perceived uncertainty. At the conclusion of the meeting [held March 26, 2009], the Data Domain board of directors confirmed that it had not been seeking a sale of Data Domain, however should NetApp elect to proceed with an offer it would merit further consideration.”

S-4 at 49.

Elegant prose this is not.

Both Data Domain and NetApp are Delaware corporations. As a Delaware corporation, Data Domain is subject to Revlon duties with respect to any change-in-control transaction (Revlon v. McAndrews & Forbes Holdings, Inc., 506 A. 2d 173 (Del. 1986)) requiring it to seek the best price reasonably obtainable on any sale of the company. As the Delaware Supreme Court made clear in its recent decision in Lyondell Chemical Co. v. Ryan, 2009 WL 1024764 (March 25, 2009, revised April 16, 2009), “[t]he duty to seek the best available price 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 of control.” 2009 WL 1024764 at *6.

So it is in this context that one can appreciate the dance engaged in by the Data Domain board in pursuing a deal with NetApp while, at the same time, declining to conduct any pre-signing market check. While concern about discussing a deal with one’s competitors is legitimate, relying upon this justification for declining to conduct any market check with strategic buyers is tricky, as the justification could justify virtually any board refusal to conduct a pre-signing market check.

Data Domain (or it least its advisors) were clearly cognizant of this balancing act in drafting the justification for the deal, as the concern over potential competitive harm from shopping Data Domain to other strategic partners pre-signing is repeated ad nauseam throughout the background discussion of the S-4.

B. EMC is Put Off While Negotiations with NetApp Continue

What raises the question of whether the Data Domain board’s concern over competitive harm in conducting a market check was pretense is its treatment of EMC. EMC did not jump into the fray with its June 1 announcement of its proposal to acquire Data Domain. On May 7, 2009, in the midst of negotiations between Data Domain and NetApp, an EMC director contacted Slootman, Data Domain’s CEO, to arrange a meeting between Slootman and EMC’s CEO, Joe Tucci, for the stated purpose of sharing with Slootman “EMC’s vision for the future.” S-4 at 52. That very day, at a meeting to discuss the negotiations between Data Domain and NetApp, the Data Domain board reviewed the EMC request. What was the board’s response?

“The Data Domain board of directors was concerned that initiating a market check at this time could jeopardize securing a firm agreement from NetApp and could disrupt Data Domain’s relationships with its current and future customers during the process. The Data Domain board of directors determined that Data Domain should move forward with the potential business combination with NetApp without contacting other companies that might be candidates for a strategic transaction with Data Domain, but that the Data Domain board of directors would continue to evaluate this strategy and consider the matter further based upon the progress and terms of the potential business combination with NetApp.”

S-4 at 53.

This is a windy way of saying “no” to EMC. Nevertheless, Tucci persisted, requesting a meeting with Slootman on Tucci’s next trip to the Bay Area. Slootman agreed to meet Tucci on May 27, 2009.

C. No Apparent Consideration of a Go Shop

Throughout its extended discussion of the negotiations with NetApp leading to the announcement of a deal on May 20, and its repeated statement of the board’s justification for not conducting a market check, there is no discussion whatsoever of why the Data Domain board did not insist on a post-signing go shop. Indeed, the initial draft of the merger agreement prepared by NetApp’s counsel, Wilson Sonsini, preposterously excluded even a fiduciary out for the Data Domain if a superior proposal were presented to Data Domain after it entered into a deal with NetApp. After Omnicare (Omnicare v. NCS HealthCare, Inc., 818 A. 2d 914 (Del. 2003)), even suggesting such a lockup is a joke, and, of course, the ultimate Data Domain/NetApp deal includes a fiduciary out and the ability to terminate the agreement if the Data Domain board receives and accepts an unsolicited superior proposal (and pays a $57 million breakup fee to NetApp). But the background discussion omits entirely any reference to negotiations over a go shop, which one would think would have been an obvious (and acceptable, if properly structured) market check mechanism if, indeed, the board’s concerns over competitive harm in conducting a pre-signing market check were legitimate.

D. Were Slootman and Bhusri Compromised?

The negotiations with NetApp on behalf of Data Domain were, as made apparent in the discussion of the background of the merger in the S-4, conducted primarily by Slootman and Aneel Bhusri, Chairman of the Data Domain board of directors. Showing less than a deft hand, Warmenhoven, NetApp’s CEO, at an early meeting, in which, apparently, only the executive officers of the two parties were present, “informed Mr. Bhusri of the potential for a role on the NetApp board of directors for Mr. Bhusri and a role in the management of NetApp for Mr. Slootman.” S-4 at 50.

While such ham-handedness might not by itself support a finding of lack of independence on behalf of Slootman or Bhusri, the potential for divided loyalty presented by such a proposal would lead some boards to either replace Bhusri as lead negotiator for the board or insist that he and Slootman be “babysat” by Data Domain’s financial advisor in all substantive negotiations between the parties. When the Data Domain board was informed of the overture, it apparently took no such action, as the description of the Data Domain/NetApp negotiations in the background discussion of the merger contains numerous examples of negotiations occurring apparently only between the principals.

E. What Might Have Been

Had EMC’s tender offer not mooted the question, it would have been interesting to see how the Delaware Chancery Court would have treated the Data Domain board of directors on any challenge to their conduct of the negotiations and approval of a merger with NetApp in the face of a Revlon challenge. As a board’s Revlon duties are explained by the Delaware Supreme Court in its recent Lyondell decision:

“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.’ That said, our courts have highlighted both the positive and negative aspects of various boards’ conduct under Revlon. The trial court drew several principles from those cases: directors must ‘engage actively in the sale process,’ and they must confirm that they have obtained the best available price either by conducting an auction, by conducting a market check, or by demonstrating ‘an impeccable knowledge of the market.’”

Lyondell Chemical Co. v. Ryan, 2009 WL 1024764 at *6 (footnotes omitted).

Under this articulation, since the Data Domain board did not conduct an auction or a market check (pre- or post-signing), they would have been left to establishing “an impeccable knowledge of the market.”

That is a defense that now need not be made, given EMC’s all-shares, all-cash tender of $30 per share. Attention will now focus on how the Data Domain board and NetApp respond to the offer.

San Antonio Fire & Police Pension Fund v. Amylin; Is There a Future For Continuing Director Poison Puts?

2009-05-19T16:39:00.000-07:00

In one of his final decisions before his retirement this July, Vice Chancellor Lamb has handed down an important ruling on continuing director poison puts, San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc. (Nasdaq: AMLN), 2009 WL 1337150 (May 12, 2009). A poison put is a contractual provision, typically found in loan agreements or indentures, that triggers adverse consequences to the debtor upon a change-in-control of the debtor. In this case the question was whether the holders of the $625 million 3% convertible notes, due 2014 (the “Convertible Notes”), acting through The Bank of New York Mellon Trust Company, the indenture trustee, would have the right to redeem the Convertible Notes (which were trading at a discount) at face value upon the occurrence of a “fundamental change” in Amylin, defined to include, among other things, a change in the makeup of the board of directors of Amylin such that the “continuing directors” would not constitute a majority of the board. “Continuing directors” included those on the board on the date of issuance of the Convertible Notes — June 2007 — and any successors who are approved by the directors then in office (or their approved successors).

The plaintiff’s allegations and the Court’s treatment of the poison put in the Convertible Notes Indenture and in Amylin’s Credit Agreement with Bank of America raise troubling questions concerning the viability of continuing director poison puts.

A. The Context

This lawsuit was triggered by a proxy contest over the directors to be elected at Amylin’s 2009 annual meeting of shareholders, to be held May 27, 2009. Twelve directors are to be elected. In January 2009 two dissident shareholders — Icahn Partners LP, an 8.8% Amylin stockholder, and Eastbourne Capital Management, L.L.C., a 12.5% stockholder — each nominated a five-person short slate for election to the board. Eastbourne, having done its homework, asked the Amylin board to take action to prevent the adverse consequences that would befall Amylin if the continuing directors’ provision of the Convertible Notes’ Indenture were triggered. Eastbourne’s proposed solution was to ask Amylin to include a “significant” number of nominees from its and Icahn’s slates in management’s slate of directors to be recommended to the stockholders.

Amylin filed its 2008 10-K with the SEC on February 27, 2009. In the 10-K, Amylin highlighted the potential adverse consequences of the continuing directors’ provisions of the Convertible Notes’ Indenture and the BofA Credit Agreement if they were triggered by election of the Icahn and Eastbourne slates. (The BofA Credit Agreement is even more restrictive than the Convertible Notes’ Indenture, in that candidates elected or appointed to the board as a result of an “actual or threatened solicitation of proxies or consents for the election or removal of Amylin directors” would not qualify as continuing directors.)

Promptly after the filing of the 10-K, Eastbourne sent a letter to the Amylin board questioning the “legitimacy” of the continuing directors’ provisions of the Convertible Notes’ Indenture and the BofA Credit Agreement, “calling upon the board to use its power to remove any obstacle to the operation of the stockholder franchise,” and calling upon Amylin to “approve” the dissident slates under the Convertible Notes’ Indenture.

On March 17, 2009, Amylin announced publicly the tentative date for its 2009 annual meeting – May 27, 2009.

B. The Litigation

Plaintiff launched a frontal assault on the continuing director provisions of the Convertible Notes’ Indenture and BofA Credit Agreement. It alleged —

• breaches of the fiduciary duties of care and loyalty by the Amylin board in its 2007 adoption of the Indenture and Credit Agreement, insofar as they both contained continuing directors covenants;

• breaches of the fiduciary duties of care and loyalty by the board in failing to approve the dissident nominees in order to “sanitize” them under the continuing directors provision of the Indenture; and

• breaches of the fiduciary duties of care and loyalty in the allegedly misleading and coercive manner in which the board disclosed the risks presented by the continuing directors provisions in the Indenture and Credit Agreement in the context of the proxy contest in Amylin’s 2008 10-K.

Besides seeking declaratory relief, plaintiff sought a mandatory injunction requiring the directors to approve the Icahn and Eastbourne nominees for director.

The plaintiff filed its class action complaint on March 24, 2009. In April the plot thickened. Clearly made a bit anxious by plaintiff’s allegations, and seeing a relatively harmless settlement strategy, Amylin and its board first filed an answer on April 7, 2009, which included a cross-claim against the Indenture trustee, seeking declaratory relief that the board has the power to approve any or all stockholder nominees at any time up to their election. And, on April 13, 2009, plaintiff and Amylin announced a partial settlement. Under the terms of the settlement, plaintiff withdrew its allegations of breach of the duty of loyalty and lack of good faith by the Amylin board. That withdrawal is important for indemnity and insurance purposes, as under Delaware GCL §102(b)(7), and Amylin’s charter, the personal liability of directors cannot be eliminated for breaches of the duty of loyalty or acts or omissions not taken in good faith. Plaintiff also agreed not to seek damages against Amylin or the board, to dismiss its claim of coercive disclosure in the 2008 10-K, and to dismiss its claim against the board for breach of fiduciary duty in failing to approve the Icahn and Eastbourne nominees. In return, the board, subject to court affirmation of its power to do so, agreed to “approve” the Icahn and Eastbourne nominees solely for the purpose of the continuing directors provision of the Indenture. This is called a clever work-around.

This “approval” did not mean that Amylin would endorse Icahn’s or Eastbourne’s nominees for election: the “approval” was solely to finesse the trigger under the Indenture permitting the Convertible Noteholders to redeem their Notes at face value. Amylin continued to oppose Icahn’s and Eastbourne’s nominees, with vigor.

Plaintiff, Amylin, and BofA also agreed to remove the BofA Credit Agreement continuing director provision from the case. Under this settlement, BofA and its group of lenders agreed to waive any event of default that might be triggered by the election of Icahn’s and/or Eastbourne’s nominees to the Amylin board, in return for — what else — money: a $625,000 fee (payable in the event that the continuing directors provision of the BofA Credit Agreement would otherwise be triggered by the election of the Icahn and/or Eastbourne nominees).

The parties then tinkered with the record before Vice Chancellor Lamb even further. On May 6, 2009, two days after close of the record date for determining the stockholders entitled to vote at the meeting, Amylin notified the Court that Eastbourne had reduced the number of candidates it was nominating to the board from five to three, and Icahn from five to two. Accordingly, even if the dissidents’ nominees are elected to the board, the board will still consist of a majority of continuing directors.

The sole remaining creditor defendant, the Indenture trustee, in response to these developments, at this point pleaded with the Court to dismiss or stay the claims against it, as the issues of the validity of the continuing director provision in the Indenture were now not ripe for determination. Plaintiff and Amylin, on the other hand, asked the Court to proceed because “whether or not the stockholder-nominated directors constitute Continuing Directors may have a significant effect on next year’s annual stockholder meeting.” 2009 WL 1337150 at *6.

C. Vice Chancellor Lamb’s Ruling

The trustee’s argument for application of the continuing directors provision of the Indenture to the Amylin proxy contest was straightforward:

“[t]he Board’s determination not to recommend the election of any of the Dissident Nominees, to recommend its own competing slate, and that the election of the Dissident Nominees would not be in the best interests of the Company—determinations that have not changed as a result of the Partial Settlement—simply cannot be reconciled with the plain meaning of the term ‘approval.’ To the contrary, such determinations by the Board clearly indicate disapproval.”

2009 WL 1337150 at *7 (footnote omitted) (emphasis in original).

Amylin, on the other hand, argued that “approval” does not mean “endorsement” or “recommendation.” “By Amylin’s reading, therefore, the board may approve a slate of nominees for the purpose of the Indenture (thus sanctioning their nomination for election) without endorsing them, and may simultaneously recommend and endorse its own slate instead.” Id.

The Vice Chancellor concluded that Amylin’s reading of the Indenture was the correct one. Clearly he was motivated by the effect of the continuing director provision upon the stockholder franchise, and he uses terms that should cause all boards considering continuing director poison puts concern:

“A provision in an indenture with such an eviscerating effect on the stockholder franchise would raise grave concerns. In the first instance, those concerns would relate to the exercise of the board’s fiduciary duties in agreeing to such a provision. The court would want, at a minimum, to see evidence that the board believed in good faith that, in accepting such a provision, it was obtaining in return extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it. Additionally, the court would have to closely consider the degree to which such a provision might be unenforceable as against public policy.”

2009 WL 1337150 at *8 (footnotes omitted).

Having concluded that the Amylin board had the power under the Indenture to “approve” a dissident’s slate under the continuing director provision of the Indenture, while at the same time opposing the election of that slate, Vice Chancellor Lamb next turned to the question of whether the Amylin board had properly approved the dissidents’ slates under the Indenture. Relying upon Hills Stores Company v. Bozic, 769 A.2d 88 (Del. Ch. 2000), the Vice Chancellor applied this test:

“… the board may approve the stockholder nominees if the board determines in good faith that the election of one or more of the dissident nominees would not be materially adverse to the interests of the corporation or its stockholders.”

Id. at *8 (footnote omitted).

Here, the Vice Chancellor ran into a problem. There was no evidence before him as to how the Amylin board came to its decision to “approve” Icahn’s and Eastbourne’s nominees or, to be more precise, the evidence before the Vice Chancellor cut the other way. First, and most obviously, the public record was replete with negative comments made by Amylin about the Icahn and Eastbourne nominees, some of which are quoted by the Vice Chancellor in note 39 to his decision. But these negative comments are not dispositive, so concluded the Vice Chancellor, because he recognized that such comments could be election “puffery” in the context of a proxy contest. In other words, the other guys’ nominees could be worse, much worse than management’s nominees, but not bad. That is a fine line to walk. The second unhelpful fact before the Vice Chancellor was the circumstance of the Amylin settlement with the plaintiff, clearly giving rise to the inference that Amylin agreed to “approve” Icahn’s and Eastbourne’s nominees to settle breach of duty and loyalty claims against its board of directors.

Exercising judicial discretion, the Vice Chancellor elected to punt on the question of whether the Amylin board properly “approved” the Icahn and Eastbourne nominees under the terms of the continuing director provision of the Indenture to a later date. It helped the Vice Chancellor in making this decision that the dissidents had reduced their slate of nominees to a number less than a majority of the Amylin board. If the dissidents are elected, and Amylin chooses to do so, then it could return to the Court for sanction of the board’s due care in “approving” the dissident nominees.

D. Did the Amylin Board Breach its Duty of Due Care in Approving the Poison Put?

The one due care issue remaining in the case that the Vice Chancellor did address is one that will give boards and their advisors pause.

The standard applied by the Vice Chancellor is one of gross negligence, that is, was the Amylin board grossly negligent in approving the Indenture with its continuing director provision? Here, the record was somewhat embarrassing, in that, in its consideration of the Indenture, the committee of the board that approved the Indenture was unaware of the poison put! So too were Amylin’s CEO and CFO! Indeed, the poison put proceeded through drafts of the Indenture without comment by Amylin or its counsel. (Indeed, there is more: when counsel was asked by the board committee whether the Convertible Notes were subject to any terms which counsel saw as “unusual or not customary,” Amylin’s counsel responded that they were not.)

Nevertheless, the Vice Chancellor concluded that the Amylin board was not grossly negligent “in failing to learn of the existence of the Continuing Directors provisions…” 2009 WL 1337150 at *10. Focusing on the board, and the advice it had received from “highly-qualified counsel,” the Vice Chancellor observed that “no one suggests that the directors’ duty of care required them to review, discuss and comprehend every word of the 98-page Indenture.” Directors can breathe a sigh of relief at that observation.

But then the Vice Chancellor concludes with words of caution to boards and their advisors:

“This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. In the context of the negotiations of a debt instrument, this is particularly troubling, for two reasons. First, as a matter of course, there are few events which have the potential to be more catastrophic for a corporation than the triggering of an event of default under one of its debt agreements. Second, the board, when negotiating with rights that belong first and foremost to stockholders (i.e., the stockholder franchise), must be especially solicitous to its duties both to the corporation and to its stockholders. This is never more true than when negotiating with debtholders, whose interests at times may be directly adverse to those of the stockholders. Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.”

Id. at *10.

E. Plaintiff Appeals

Not satisfied with the Vice Chancellor’s blessing of its strategy for finessing the continuing director provision of the Indenture, plaintiff has appealed the Vice Chancellor’s ruling deferring a decision on whether the Amylin board exercised due care in “approving” the dissidents’ shortened slate of director nominees. Plaintiff essentially doesn’t like the uncertainty created by the Vice Chancellor’s ruling. In its application for an expedited hearing before the Delaware Supreme Court, it argues that, in the absence of an expedited final resolution prior to the date of the stockholder meeting, “stockholders will be coerced from voting for the five stockholder nominees because of the cloud cast by the lower Court’s ruling.” Plaintiff’s Motion for Expedited Scheduling Regarding Dismissal of Count III, dated May 13, 2009, at 2. Justice Jacobs of the Delaware Supreme Court denied the motion for an expedited hearing on May 15.

F. Whither the Continuing Director Poison Put?

If Vice Chancellor Lamb’s decision stands, it is hard to see how continuing director poison puts will survive. If drafted more restrictively, to protect lenders, it could subject a board to claims of entrenchment and thereby implicate the duty of loyalty, stripping from the directors the “due care” waivers permitted in charter provisions such as those permitted by Delaware GCL §102(b)(7). As to existing poison puts, plaintiff’s strategy in this lawsuit provides a roadmap on how to neuter them, although the path that a board must follow is akin to Ulysses’ travels between Scylla and Charybdis: how to “approve” a dissident slate while at the same time slamming them in the heat of battle.

Breaches of continuing director provisions are not, of course, monetary defaults. They provide a signal to lenders of potential trouble. A more classic way of signaling such trouble is through the use of financial covenants, e.g., debt to equity ratios, debt service coverage, or through events of default that foreshadow trouble, such as a rating decline, or through negative covenants such as a requirement to secure the lenders’ consent for any merger, consolidation, etc. Debtors and their counsel will in all likelihood point lenders to reliance upon these types of provisions in lieu of reliance upon continuing director poison puts (assuming, of course, it is the lenders who are the parties requesting continuing director poison puts).

FLI Deep Marine LLC v. McKim; the Futility of Claiming Demand Futility After a Demand Has Been Made

2009-05-13T10:36:00.001-07:00

Much of the law can be a trap for the unwary. This is particularly true with procedure. Even experienced counsel can blow it. Such appears to have been the case with plaintiffs’ counsel in this derivative action. By his letter opinion of April 21, 2009 (2009 WL 1204363) Vice Chancellor Noble dismisses this derivative action for plaintiffs’ failure to allow the board of directors of Deep Marine Holdings, Inc. (“DMT”) adequate time to respond to plaintiffs’ litigation demand.

A. Plan Ahead

Plaintiffs complained that DMT had been looted for personal gain for some four years by its controlling shareholders, acting through their controlled directors, also named as defendants in the lawsuit. But plaintiffs filed their action after plaintiffs’ counsel had demanded of the board that it take remedial action and appoint a special litigation committee to investigate the alleged breaches of duty. In response to the demand, the board established a special litigation committee, comprised of two of the defendant directors.

Notwithstanding the making of their demand, in their post-demand lawsuit, plaintiffs alleged that demand on the board was futile and should be excused, notwithstanding that they had already made one!

B. The Law Is the Law

Chancery Rule 23.1 requires that a shareholder seeking to assert a claim on behalf of a Delaware corporation to first make demand on the directors to obtain the action desired, or “state with particularity the reasons for the shareholder’s failure to make such effort.” Letter Opinion at 6-7.

The action of a board in responding to a demand is generally subject to review under the “deferential” business judgment rule, “which presumes that a board is independent, and acts reasonably and in good faith.” Letter Opinion at 7. Where a derivative plaintiff seeks to avoid demand and proceed directly with litigation on behalf of the corporation, then the inquiry focuses on “director independence” and “disinterestedness,” which plaintiff can rebut by alleging particularized facts challenging the independence of the directors and creating “a reasonable doubt that the challenged conduct was a valid exercise of business judgment.” Id.

However, where a shareholder chooses to make a demand upon a board, then the shareholder “concedes the independence of a majority of the board.” Id. at 8. In such circumstances, the Chancery Court “only examines the good faith and reasonableness of the board’s investigation.” Because plaintiffs in this action made a pre-suit demand upon DMT’s board of directors, “they have conclusively conceded the independence of the Board, and are precluded from now arguing that demand should be excused because the directors are conflicted.” Id. at 8. The Vice Chancellor reaches this conclusion notwithstanding plaintiffs’ pleas that, given the makeup of the special committee appointed to respond to their demand, the exercise would be a “mockery,” “contrived,” and a “farce.” While, based upon the allegations of the complaint, plaintiffs might well be correct, too bad: the Court “cannot diverge from settled law.” Id. at 9.

In words that undoubtedly cause plaintiffs’ counsel considerable heartburn, the Vice Chancellor observes that, yes, their demand may very well have been a misstep:

“In light of these facts [plaintiffs’ allegations of the lack of independence of the board], the Plaintiffs’ decision to make a demand upon the Board appears inprovident. The Plaintiffs ask the Court to undo the consequences of their demand; this Court will not part ways with established Delaware law to grant the Plaintiffs relief from a strategic decision they now regret.”

Id. at 10.

C. Spiegel v. Buntrock

This has happened before. It seems to be a habit of derivative plaintiffs. In a similar vein, the Delaware Supreme Court, in Spiegel v. Buntrock, 571 A.2d 767 (1990), likewise concluded that, when a shareholder makes a pre-suit demand, the shareholder “tacitly concedes the independence of a majority of the board to respond.” 571 A.2d at 777. The facts of Spiegel were even more dramatic: Spiegel first filed his derivative action. When respondents protested that he had not made a pre-suit demand, Spiegel dutifully responded by filing a demand! Gotcha! Once such demand is made, then the business judgment rule applies to the board’s response to the demand, and the issues on review of any board decision “are solely the good faith and reasonableness of the committee’s investigation.” 571 A.2d at 778, citing Zapata Corp. v. Maldonado, 430 A.2d 779, 787 (1981). The focus is on process, not the ultimate decision, since that decision is not subject to judicial review. Id.

So it’s back to the drawing boards for plaintiffs in this case. If defendant DMT’s advisors have any brains, the special committee will follow accepted practice, appoint one or more disinterested directors, advised by special counsel, and reach the inevitable decision not to litigate. Only if DMT is foolish enough to leave the decision on how to respond to the demand in the hands of directors who are alleged, through particularized pleading, to have engaged in misconduct, would plaintiffs have a shot at claiming the board’s response was not one made in “good faith.”

Nemec v. Shrader; Redemption of Shares Just Prior to a Transaction

2009-05-09T14:16:00.000-07:00

Timing can be everything. Long-time “partners” Joseph Nemec and Gerd Wittkemper of Booz Allen Hamilton Inc. (“Booz Allen”) retired on March 31, 2006 after illustrious careers with the firm. After their retirement, Booz Allen entered into negotiations with The Carlyle Group (“Carlyle”) to sell its government consulting business for over $2 billion. Notwithstanding assurances by Booz Allen’s chairman and CEO to both Nemec and Wittkemper that Booz Allen would not exercise its discretionary option to repurchase their shares prior to consummation of the Carlyle transaction, Booz Allen in fact did so a month before Booz Allen entered into a deal with Carlyle. The early redemption cost Nemec and Wittkemper over $60 million.

Too bad, concluded Chancellor Chandler on this motion of defendants to dismiss (reported at 2009 WL 12043465 (April 30, 2009)). The discretionary redemption did not constitute a breach of the directors’ fiduciary duties to Nemec and Wittkemper, did not breach the implied covenant of good faith and fair dealing between plaintiffs and Booz Allen, and did not constitute unjust enrichment of Booz Allen. It’s a harsh result, which may feed the Chancery Court’s reputation as plaintiff-unfriendly, but undoubtedly the correct decision.

A. The Background

Nemec spent 36 years with Booz Allen. At the time of his retirement on March 31, 2006, he ranked third in seniority among all Booz Allen “partners.” (Although a Delaware corporation, the firm, originally founded as a partnership in 1914, retained the “attitude and culture” of a partnership.) He sat on Booz Allen’s board of directors where, among other things, he served on the audit committee. Wittkemper retired on the same date, March 31, 2006, after some 20 years as a partner of the firm, building the firm’s German business and helping it to expand throughout Europe.

At the time of his retirement from the firm, Nemec owned 76,000 shares of Booz Allen (representing 2.6% of the issued and outstanding stock of the firm), and Wittkemper owned 28,000 shares. Under Booz Allen’s stock plan, a retiree had a “put” right, for a period of two years from the date of his retirement, to sell his shares back to the firm for book value. After expiration of the two-year put period, Booz Allen had the right to redeem part or all of a retired officer’s stock, also at book value (as of the time of redemption). Nemec and Wittkemper (in large part) retained their Booz Allen stock after retirement. In early 2007 Booz Allen commenced discussions with Carlyle over the sale of its government consulting business. Carlyle submitted a bid in November 2007 to purchase the business for $2.54 billion. The negotiations became public in January 2008; it was reported the deal was expected to close by March 31, 2008 (the end of Booz Allen’s fiscal year). If it closed by that date, Nemec and Wittkemper would participate in the benefits of the transaction, to the extent of some $700 per share.

In light of the pending transaction, Booz Allen’s board elected, in March 2008, to preserve the status quo of Booz Allen’s stock ownership, meaning it elected not to redeem any shares so as to maintain the status quo and not “disfavor any existing stockholder.” Slip Opinion at 5-6.

Nemec and Wittkemper, aware of the pending transaction, were of course anxious to participate in its fruits. Booz Allen’s chairman and CEO gave assurance to both of them that they would remain Booz Allen stockholders until the close of the transaction. The CEO stated that this was an “easy moral decision.” Slip Opinion at 6.

Moral, maybe, but on second thought, the board eschewed morality and decided to exercise the firm’s contractual rights under the stock plan and award agreements with Nemec and Wittkemper: in April 2008, before the transaction with Carlyle was formally approved, Booz Allen redeemed the plaintiffs’ shares at the pre-transaction book value — $162.46 per share.

Within weeks of the redemption of Nemec’s and Wittkemper’s shares, the firm moved to cement the transaction with Carlyle. On May 15, 2008, it entered into a merger agreement to sell its government business to Carlyle, which was announced publicly the following day. The directors of Booz Allen, who owned more than 300,000 shares, benefited by the redemption of the plaintiffs’ shares to the tune of $6 million.

B. The Fiduciary Duty Claim

Plaintiffs first claimed that the Booz Allen directors breached their duty of loyalty to plaintiffs by exercising the firm’s option to redeem plaintiffs’ shares at the pre-Carlyle value of the shares. Notwithstanding the personal benefits derived by the directors from this decision, Chancellor Chandler was unimpressed by the claim. First, the dispute fundamentally involved a contract — the award agreement setting forth the firm’s and Nemec’s and Wittkemper’s rights with respect to their stock awards under the stock plan:

“If the ‘fiduciary claims relate to obligations or they are expressly treated’ by contract then this Court will review those claims as breach of contract claims and any fiduciary claims will be dismissed.”

Slip Opinion at 8 (footnote omitted).

The Chancellor’s interpretation of the directors’ action was a matter of contract interpretation:

“Whether the Directors possessed the right to redeem plaintiffs’ shares and whether the Directors properly exercised that right is simply a matter of contract interpretation.”

Slip Opinion at 8-9.

Going beyond where he had to, the Chancellor nevertheless reached plaintiffs’ fiduciary duty claims, and rejected them. Fatal to plaintiffs’ fiduciary duty claim was their assertion that the Booz Allen board, as fiduciaries, owed “unique” duties to them. In fact, the directors’ decision to redeem plaintiffs’ shares benefitted all other shareholders, not just the directors as shareholders. Quoting from Gilbert v. El Paso, Chancellor Chandler noted that in such instances the fact that an action may adversely affect the interests of particular shareholders is of no moment:

“[D]irectors may take whatever action that, in their proper exercise of business judgment, will best serve the interests of the corporation or the entire body of shareholders. That such action may adversely affect the interests of a particular shareholder subgroup, will, in certain instances, be unavoidable. Nonetheless, no wrong doing will have occurred if the directors are able to justify the result as furthering a paramount or overriding corporate or shareholder interest.”

Slip Opinion at 9, quoting from Gilbert v. El Paso, 1998 WL 124325 at *10 (Del. Ch. 1988), aff’d, 575 A.2d 1131 (Del. 1990).

C. Good Faith and Fair Dealing Claim

The strongest of plaintiffs’ claims was that by redeeming their shares Booz Allen violated the implied covenant of good faith and fair dealing. Plaintiffs argued that when a contract confers discretion on a party, that party is required to make the decision reasonably and in good faith. Relying upon the principle that imposing obligations upon contracting parties through the covenant of good faith and fair dealing is “a cautious enterprise and instances [of its application] should be rare,” Slip Opinion at 11, citing Superior Vision Services, Inc. v. ReliaStar Life Ins. Co., 2006 WL 2521426 (Del. Ch. 2006), the Chancellor concluded that no violation occurred here because Booz Allen exercised rights specifically granted to it under the stock plan and award agreements with plaintiffs:

“The Stock Plan is a negotiated instrument entered into freely by both parties. The implied covenant is not implicated simply because Booz Allen, by exercising its option, received the fruits of the agreed to bargain under the stock plan. Nor is the implied covenant implicated because the exercise of the option had a negative effect on plaintiffs’ bottom line.”

Slip Opinion at 12.

D. Unjust Enrichment Claim

Chancellor Chandler tarried only a moment over this claim, noting that it applies only when it would be “unconscionable” to allow a party to retain a benefit, and the Delaware courts “have consistently refused to permit a claim for unjust enrichment when the alleged wrong arises from a relationship governed by contract.” Slip Opinion at 13.

E. What Might Have Been

One cannot read this decision without thinking of the famous case of Jordan v. Duff and Phelps, Inc., 815 F.2d 429 (7th Cir. 1987), discussed in my post of September 6, 2008. Jordan also involved an employee who terminated his employment with his employer (Jordan left to take another job). Unbeknownst to Jordan at the time he quit (he also received the book value of his shares of stock), his employer, Duff and Phelps, was in negotiations to merge. Had Jordan hung around longer, he would have received substantially more for his shares.

In this celebrated decision, in which Judges Easterbrook and Posner took opposing sides (Easterbrook for the majority, Posner in dissent), the Seventh Circuit concluded that, in such circumstances, Duff and Phelps had breached its duty of full disclosure to Jordan in connection with the redemption of his stock.

Jordan would have been in play in this case if Booz Allen had begun negotiations with Carlyle before Nemec and Wittkemper announced their decisions to retire in March 2006. But, as noted by Chancellor Chandler, the negotiations with Carlyle “began to emerge” in early 2007, too late for Nemec and Wittkemper to reach for Jordan v. Duff and Phelps. Too bad. Timing is everything.

Lyondell Chemical Co. v. Ryan; The Limits of Bad Faith Claims

2009-03-30T15:42:00.000-07:00

In an en banc decision handed down March 25, 2009, the Delaware Supreme Court took Vice Chancellor Noble to the woodshed for his refusal to grant the Lyondell board summary judgment against plaintiffs over the board’s approval of the merger of Lyondell and a subsidiary of Basell AF (“Basell”) in December 2007 for a cash price of $48 per share. The decision provides important clarification of the Revlon duties of a disinterested board, and makes clear that where a board is disinterested, establishing bad faith is a steep hill to climb.

A. The Weakness of the Vice Chancellor’s Decision

I commented on Vice Chancellor Noble’s Lyondell decision by my posts of September 11, 12 (comparing the Vice Chancellor’s decision in Ryan with Vice Chancellor Strine’s decision In re Lear Corporation Shareholder Litigation) and 15, 2008. As I noted in my post of September 11:
“Given that a finding that a board has failed to act in good faith ‘requires conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence),’ Stone v. Ritter, 911 A.2d 362, 369 (Del. 2006) (footnote omitted), the most surprising aspect of Vice Chancellor Noble’s opinion is that he devotes only three pages of his 73-page opinion to disposing of the defendants’ argument that, even if they breached their Revlon duties, Lyondell’s certificate and GCL § 102(b)(7) precluded an award of damages.
. . . .

What is surprising about the Vice Chancellor’s conclusion is that he devotes almost no effort to explicating Stone v. Ritter’s use of the word ‘conscious’ before ‘disregard for their responsibilities . . .’ as applied to Ryan. It’s almost as if, at this point in his struggle over this decision, he had little left to analyze whether additional culpability were required from the Lyondell board to find not only a breach of Revlon duties but also a conscious violation of their Revlon duties.”

B. The Supreme Court’s Rebuff

The Delaware General Corporation Law permits the inclusion, in a certificate of incorporation, of provisions limiting the personal liability of directors of a Delaware corporation for due care violations (including gross negligence), but not “for acts or omissions not in good faith, which involve intentional misconduct or a knowing violation of law . . .” Because this was a case where Vice Chancellor Noble concluded that on the evidence before him the Lyondell board was independent and not motivated by self-interest or ill will, the issue was whether the directors breached their duty of loyalty to Lyondell by failing to act in good faith.

Reviewing its prior decisions in Disney (In re Walt Disney Derivative Litigation, 906 A.2d 27 (Del. 2006)) and Stone v. Ritter, 911 A.2d 362 (Del. 2006), the Supreme Court, in an opinion by Justice Berger, emphasized the scienter required to establish bad faith by a Delaware board:

“Stone also clarified any possible ambiguity about the directors’ mental state, holding that ‘imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.’”

Slip Opinion at 11.

In concluding that Vice Chancellor Noble erred on the record before him in refusing to grant the defendants’ summary judgment, the Supreme Court crucially disagreed with the Vice Chancellor that the board’s Revlon duties began with Basell’s filing of a Schedule 13D in May 2007. In response to the filing, the Lyondell board took a “wait and see” approach, for which they were faulted by Vice Chancellor Noble. In this the Vice Chancellor was wrong:

“The problem with the trial court’s analysis is that Revlon duties do not arise simply because a company is ‘in play.’ The duty to seek the best available price 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 of control. [The Lyondell board’s ‘wait and see’ approach] was an entirely appropriate exercise of the directors’ business judgment. The time for action under Revlon did not begin until July 10, 2007, when the directors began negotiating the sale of Lyondell.”
Slip Opinion at 14-15 (footnotes omitted).

Vice Chancellor Noble, after his review of the Revlon line of cases, concluded that directors must engage actively in a sales process, and must establish that they have obtained the best available price “either by conducting an auction, by conducting a market check or by demonstrating ‘an impeccable knowledge of the market.’” Slip Opinion at 16-17 (quoting from the Vice Chancellor’s opinion).

The Lyondell board admittedly did not conduct an auction or a market check before signing up with Basell, and Vice Chancellor Noble found that they could not demonstrate that they had an “impeccable” market knowledge of Lyondell’s industry and propects. But the Vice Chancellor’s analysis was directed at the wrong question. The issue is not whether the Lyondell board exercised due care, but whether the board failed to act in good faith. That is a very different analysis, and using that analysis, the record before the Vice Chancellor mandated entry of judgment in favor of the directors.

At this point the Supreme Court took the opportunity to quote (and thereby praise) Vice Chancellor Strine from his decision in Lear, discussed in my post of September 12, 2008. The following language will surely be quoted by all defendant directors in future claims alleging disloyalty:

“Directors’ decisions must be reasonable, not perfect. ‘In the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.’ [Quoting Vice Chancellor Strine in Lear.] The trial court denied summary judgment because the Lyondell directors’ ‘unexplained inaction’ prevented the court from determining that they had acted in good faith. But, if the directors failed to do all that they should have under the circumstances, they breached their duty of care. Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty. The 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.”

Slip Opinion at 18-19 (footnotes omitted).

C. Observations

Lyondell illustrates the crucial protection provided directors by charter document exculpatory provisions such as those allowed by Section 102(b)(7) of the GCL and by the corporation laws of other states. With such provisions, directors’ exposure for monetary damages for breach of due care claims can be virtually eliminated. While these provisions do not prevent claims seeking injunctive relief for due care violations, they provide critical protection to directors against damages for due care violations. Indeed, an individual would be ill advised to join a board without exculpatory protections such as those permitted by Section 102(b)(7) or like provisions in other jurisdictions.

The other lesson of Lyondell is the benefit of accelerated deal negotiations. Dan Smith, Lyondell’s CEO, in response to overtures by Basell’s controlling shareholder, Leonard Blavatnik, negotiated what appeared to be a fully-priced deal (getting Blavatnik to raise his offer from $40 per share to $48 per share). In response, Blavatnik insisted that the deal be accepted and a merger agreement entered into in one week. While the accelerated schedule, the lack of a market check, the board’s acceptance of Smith’s price-raising efforts without its further insistence on further price enhancements, and the board’s acceptance of deal enhancement features (hefty break-up fee, no-shop covenant, and limited poison pill waiver) deeply troubled Vice Chancellor Noble, they did not, on the full record, trouble the Delaware Supreme Court, certainly not on the question of whether the Lyondell board acted in conscious disregard of its fiduciary duties. It of course did not hurt the directors’ cause that no competing suitor surfaced during the four months between the announcement of the merger agreement and the stockholders’ meeting, or that the stockholders approved the deal by more than 99% of the voted shares, or that, as is now common knowledge, Basell, in light of the cratering of the world economy, has put Lyondell in Chapter 11.

So, as a result of the Court’s decision in Lyondell, I would expect suitors, certainly in deals believed to be fully priced, to insist upon an accelerated deal schedule, at least to the point of negotiating and announcing an agreed-upon merger agreement.

CSX v. TCI; Sacre Bleu! Christopher Hohn Elects Not to Stand for Re-Election to the CSX Board

2009-02-19T10:42:00.000-08:00

After over a year of effort, the expenditure of over $10 million in legal fees, the burden of engaging in bare-knuckles litigation, and the humiliation of being “dressed down” by an outraged Judge Lewis Kaplan (CSX v. TCI, 562 F. Supp. 2d 511 (S.D.N.Y. 2008)), Christopher Hohn won his proxy contest with CSX, seating himself and three others on the CSX board at the shareholders’ meeting held June 25, 2008 (CSX did not sit Hohn until September 2008).

Hohn, whose hedge fund, the Children’s Investment Master Fund, rose like a shooting star among activist hedge funds, carefully examined CSX and the opportunity a change in management at the company might represent, and presented a well researched and effective campaign for shareholder votes. In its “case for change,” TCI stated its belief that:

• CSX could be the best railroad in America; and

• Its earnings power could be double what the management of CSX had targeted to achieve.

The question, TCI asked, “shouldn’t be ‘Where has CSX come from?’ but ‘Where should CSX be?’” Hohn’s nominees would “refresh” the CSX board, and bring more railroad experience and more business experience to CSX than the five directors TCI’s group hoped to supplant, and bring to the CSX board “the perspectives of large and engaged shareholders.”

This was slick stuff. Given TCI’s reputation for shaking things up, which Hohn had done with Deutsche Börse and ABN Amro, the campaign succeeded.

But “engaged” Hohn no longer is: in a brief announcement on February 10, 2009, CSX disclosed that Hohn had notified the Governance Committee of CSX’s Board that he did not wish to be included as a nominee for re-election as a director at the annual meeting scheduled for May 6, 2009. CSX reports that Hohn “informed the Company that this decision resulted from his responsibilities in managing his business interests.”

Hohn’s possible burnout with activist investing was foreshadowed last fall in an article in Alpha (September 19, 2008), entitled “Christopher Hohn Rethinks Activism.” Spending over $10 million going against incumbent management, and losing money, as TCI has done with Deutsche Börse, will do that to you. Given the current economy, TCI has not done too well at CSX either. On June 25, 2008, the date of CSX’s 2008 annual meeting, CSX closed at $63.23. Yesterday, February 18, 2009, CSX closed at $27.83, a 56% decline since the shareholder meeting. And Hohn’s perception of the CSX opportunity — that its monopolistic position would benefit from a combination of global economic growth and higher energy costs, has vaporized in the current downturn.

Hohn, and other activist investors, have undoubtedly grown to appreciate the power of incumbency. As Hohn ruefully observed for the Alpha article:

“Buffett has always said that he looks for good management teams, because they’re easier to work with,” Hohn says. “We’ve often done just the opposite. We’ve frequently looked for excellent companies with underperforming management — Deutsche Börse, Euronext, CSX. Activism has been profitable for us, but it’s getting much harder; the political and regulatory environment is changing.”

In with a big bang, out with a whimper.

And we are still awaiting the decision of the Second Circuit Court of Appeals on Judge Kaplan’s searing decision finding TCI had violated the Exchange Act in its campaign to replace five members of the CSX board (the panel promptly ruled with Judge Kaplan that, even if TCI had violated the Exchange Act, the votes that it obtained for its slate would not be nullified, but its full opinion on this issue and on Judge Kaplan’s judgment on liability has yet to be handed down).

For my prior commentary on this case, see my posts of November 11, September 15, August 23, August 13, August 1, July 30, July 26, July 17, June 24, and June 23, 2008.

Gantler v. Stephens; Board's Failure to Accept Merger Proposal to Pursue Reclassification of Stock Not Entitled to Presumption of Business Judgment

2009-02-13T15:07:00.000-08:00

The Delaware Supreme Court’s en banc decision in Gantler v. Stephens, 2009 WL 188828 (January 27, 2009) illustrates the hazards of pursuing change of control transactions lackadaisically and the risks in alienating a sitting director. As a result, decisions that might normally be protected by the business judgment rule received more exacting entire fairness review. Under the more exacting standard, the Delaware Supreme Court concluded, in an opinion by Justice Jacobs, that the defendants’ motion to dismiss had been improperly granted by Vice Chancellor Parsons. In the course of its decision, the Supreme Court takes the occasion to confirm that officers are subject to the same fiduciary duties as directors under Delaware law, and clarifies the application of the doctrine of shareholder ratification.

A. How Not to Run a Transaction

First Niles Financial, Inc. (“First Niles” or the “Company”) is a Delaware corporation headquartered in Niles, Ohio. It is a holding company formed as the result of the demutualization of a single branch S&L (the “bank”) located in Niles. Its board of directors was insular, consisting of First Niles’ long-time Chairman, President and CEO William L. Stephens, plaintiff Leonard T. Gantler (director from April 2003 through April 26, 2006 and a CPA), James Kramer, president of a local heating and air conditioning company that provided services to the bank and for whom the bank was a major client, Ralph Zuzolo, principal in a Niles law firm that provided legal services to the bank and the sole owner of a real estate title company that provided title services for nearly all of the bank’s real estate transactions, and a fifth director.

In August 2004 the board decided to put the Company up for sale. It retained Keefe, Bruyette & Woods as its financial advisor.

Demonstrating its lack of enthusiasm for the proposal, management, headed by Stephens, advocated abandoning the search at the very next meeting of the board and proposed, instead, that the Company go private. The board took no action on management’s proposal. Three potential purchasers surfaced. Two of them were explicit that they would replace the Company’s board. Keefe Bruyette advised the board that all three bids reasonably valued the Company.

Notwithstanding the board’s direction to management and Keefe Bruyette to conduct due diligence in connection with two of the proposals, management failed to provide due diligence materials to one of the bidders, resulting in its withdrawal of its proposal. The remaining bidder, First Place Financial Corp. (“First Place”), after itself being delayed with its due diligence requests, proposed a stock-for-stock transaction which, as revised, represented an 11% premium over First Niles’ stock price. Keefe Bruyette opined that the offer was within an acceptable range.

Here is the Court’s recitation of the sum and substance of the board’s consideration of First Place’s revised proposal:

“On March 8, First Place increased the exchange ratio of its offer to provide an implied value of $17.37 per First Niles share. At the March 9 special Board meeting, Stephens distributed a memorandum from the Financial Advisor describing First Place’s revised offer in positive terms. Without any discussion or deliberation, however, the Board voted 4 to 1 to reject that offer, with only Gantler voting to accept it. After the vote, Stephens discussed Management’s privatization plan and instructed Legal Counsel to further investigate that plan.”

Slip Opinion at 7.

B. Management’s Reclassification Proposal

After the board rejected First Place’s offer, it thereafter considered management’s privatization proposal which included, among other components, reclassifying the shares of holders of 300 or fewer shares of the Company’s common stock into a new issue of Series A Preferred Stock, which would pay higher dividends but not carry any voting rights (except in the event of the proposed sale of the Company) (the “Reclassification Proposal”). In December 2005, after hearing a presentation from Powell Goldstein LLP, Atlanta, as special counsel retained for the privatization, the board elected to proceed with the Reclassification Proposal by a vote of three to one, with Gantler dissenting.

After Gantler resigned from the board in April 2006, the board elected to proceed with the Reclassification Proposal in June of 2006, which, because it entailed an amendment to the Company’s Certificate of Incorporation, required stockholder approval.

C. The Company’s Proxy Statement

In its proxy statement distributed to its stockholders soliciting their approval of the Reclassification Proposal and the amendment to the Company’s Certificate of Incorporation, the proxy statement acknowledged that the Company’s directors and officers were subject to a conflict of interest with respect to the Reclassification Proposal. In disclosing the alternatives the board had considered to the Reclassification Proposal, the proxy statement stated, with respect to the First Place proposal, that “[a]fter careful deliberations, the board determined in its business judgment the proposal was not in the best interests of the Company or our shareholders and rejected the proposal.” Slip Opinion at 10.

57.3% of the outstanding shares voted in favor of the Reclassification Proposal, although, with respect to shares held by stockholders not affiliated with management, the proposal passed by a bare 50.28% majority vote.

D. Business Judgment Standard Not Available to the Company’s Board

In reviewing Vice Chancellor Parsons’ grant of defendants’ motion to dismiss, the Supreme Court reviewed plaintiffs’ complaint “in the light most favorable to the non-moving party, accepting as true its well-pled allegations and drawing all reasonable inferences that logically flow from those allegations.” Slip Opinion at 12-13 (footnote omitted).

The Supreme Court first agreed with Vice Chancellor Parsons that the Unocal standard of review did not apply (Unocal v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1995)) because the conduct challenged did not involve any “defensive” action by the Company’s board:

“The Court of Chancery properly refused to apply Unocal in this fashion. The premise of Unocal is ‘that the transaction at issue was defensive.’ Count I [alleging breach of fiduciary duty in the conduct of the sales process] sounds in disloyalty, not improper defensive conduct. Count I does not allege any hostile takeover attempt or similar threatened external action from which it could reasonably be inferred that the defendants acted ‘defensively.’”

Slip Opinion at 17 (footnotes omitted).

But the Supreme Court did find that Vice Chancellor Parsons misapplied the business judgment rule. A board is entitled to the protection of the business judgment rule unless the plaintiff pleads facts supporting either a breach of the board’s duty of loyalty or its duty of care. Here plaintiffs alleged that the First Niles board improperly rejected a “value-maximizing” bid from First Place and terminated the sales process to preserve personal benefits and valuable outside business opportunities for management and the interested directors.

While a board’s decision not to pursue a merger opportunity is normally reviewed within the traditional business judgment framework, that framework is not available to defendants where plaintiffs plead facts establishing a cognizable claim that a board acted disloyally. Here the plaintiffs did so. The Supreme Court had little difficulty in finding that three of the four directors who rejected the First Place bid acted, on the facts pled, disloyally: Stephens, by his failure to cooperate with the bidders; Kramer because he suffered from a “disqualifying” conflict by reason of his dependence upon the bank as a major client of his service company; and Zuzolo likewise because of his heavy reliance upon the bank for his income.

In the course of its analysis, the Supreme Court takes the occasion to expressly affirm that officers of Delaware corporations owe the same fiduciary duties to stockholders as directors do:

“In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold."

Slip Opinion at 24 (footnotes omitted).

(In so holding, the Court notes that corporate officers, unlike corporate directors, are not expressly included in Section 102(b)(7) of Delaware’s GCL, permitting the certificate of incorporation of a Delaware corporation to include a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders from monetary damages for breach of fiduciary duty, subject to specified exceptions. Expect this omission to become an agenda item for the Delaware Legislature. The Court’s holding also points up the importance of indemnification agreements for officers.)

E. Clarification of the Shareholder Ratification Doctrine

The Supreme Court also takes the occasion of this decision to clarify the application of Delaware’s shareholder ratification doctrine. Vice Chancellor Parsons concluded that the approval by the stockholders of First Niles of the Reclassification Proposal “ratified” the board’s decision to pursue it, thereby entitling it to business judgment protection. The Supreme Court reversed this decision and takes the occasion to clarify that the shareholder ratification doctrine is limited to its “classic” form, meaning that it applies only where shareholders vote to approve director action that is not legally required of the shareholders in order for the action to become legally effective:

“To restore coherence and clarity to this area of our law, we hold that the scope of the shareholder ratification doctrine must be limited to its so-called ‘classic’ form; that is, to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective. Moreover, the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. . . . the ‘cleansing’ effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review, as opposed to ‘extinguishing’ the claim altogether (i.e., obviating all judicial review of the challenged action).”

Slip Opinion at 33-34 (footnotes omitted) (emphasis in original).
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There are two sets of losers as a result of the Supreme Court’s reversal of Vice Chancellor Parsons’ ruling. First there are the defendants, whose management of the First Niles sales process and consideration and adoption of the Reclassification Proposal comes across as amateurish and transparently self-interested. The second loser is Vice Chancellor Parsons himself, whose rulings and reasoning are treated brusquely by the Supreme Court, almost as if they concluded he had been tone deaf to the self-interested conduct of the First Niles board. Vice Chancellor Parsons took some seven months to prepare his opinion below (the case was submitted to the Vice Chancellor on July 11, 2007 and he decided it on February 14, 2008): his bosses showed little regard for all that work.

Rohm and Haas Company v. The Dow Chemical Company; Rohm and Haas Sues For Specific Performance of Merger Agreement -- Dow Responds: "Let's Do Therapy"

2009-02-09T16:42:00.000-08:00

A. Rohm and Haas’ Complaint

Rohm and Haas’ complaint, filed in the Delaware Chancery Court on January 26, 2009, is well-drafted and to the point: Rohm and Haas and Dow (through a wholly-owned subsidiary organized solely for the purpose of facilitating the merger) entered into a merger agreement on July 10, 2008 calling for the combination of the two companies in consideration of the cash payment by Dow of $78 for each share of Rohm and Haas common stock (Rohm and Haas’ common closed today, February 9, at $56.28). All conditions to completion of the merger, including Federal Trade Commission (“FTC”) clearance, were satisfied by January 23, 2009. Notwithstanding that the merger was teed up for closing, Dow has refused to close.

Because the merger was negotiated when the credit markets were already in turmoil, Rohm and Haas negotiated measures designed to provide certainty of closure, including (i) the absence of any financing condition, (ii) securing from Dow a representation that it would have sufficient funds at closing to consummate the merger, (iii) a restrictive MAC definition (thus limiting the circumstances under which Dow could back out of the merger), and (iv) an explicit acknowledgement by Dow that ROH would be entitled to specific performance to enforce the merger agreement:

“The parties agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms or were otherwise breached and that the parties would not have any adequate remedy at law. It is accordingly agreed that the parties shall be entitled to an injunction or injunctions to prevent breaches or threatened breaches of this Agreement and to enforce specifically the terms and provisions of this Agreement . . . The foregoing is in addition to any other remedy to which any party is entitled at law, in equity or otherwise.”

Merger Agreement § 8.5(a); quoted in Complaint ¶ 17.

One of the events precipitating Dow’s cold feet was the failure of “K-Dow,” a planned joint venture between Dow and Petrochemical Industries Company of Kuwait, a wholly-owned subsidiary of Kuwait’s state oil company. That joint venture, announced December 2007 (before the announced merger of Dow and Rohm and Haas) would have provided Dow with $9.5 billion in cash proceeds, which would have been available to Dow to consummate the merger with Rohm and Haas. However, formation of K-Dow was not a condition to close of the Dow/Rohm and Haas merger. Furthermore, Dow secured debt and equity financing commitments totaling $17 billion in connection with the proposed merger with Rohm and Haas, more than enough to fund the $15 billion plus cost of the merger, although, again, the securing of such debt and equity financing was not a condition to Dow’s obligation to close the merger.

B. Dow’s Response

Dow’s response, filed with the Chancery Court on February 3rd, is one of the strangest pleadings this reader has ever reviewed. It reads more like a John McPhee essay intended for William Shawn’s New Yorker than a legal pleading. It essentially asks Chancellor Chandler (to whom the case has been assigned) to adopt a “holistic” approach to the dispute, taking into account, so urges Dow, not only the interests of Rohm and Haas’ stockholders but also the other constituencies that might be affected by a Dow/Rohm and Hass merger — the companies’ employees, creditors, suppliers, and the communities in which the companies operate. A few selections from the 62-page answer illustrate Dow’s pitch:

“. . . Rohm and Haas turns a blind eye to the very difficult issue that the Court now confronts — whether the forced integration of tens of thousands of jobs and the judicial creation of a new entity is equitable considering all of the relevant legal interests. [Emphasis in original.] Contrary to the Complaint’s suggestion, the interests of Rohm and Haas shareholders who control the company today would have no contractual rights whatsoever to consummation of the merger — and no stake in its future prospects — are not dispositive.

This is a case with strongly competing interests that have to be weighed. There are no black and white hats or simple answers, only intimidating and evolving uncertainties that must be thoroughly understood before any irreversible action is taken. . . . .

. . . .

Dow has charted a path forward, urged Rohm and Haas . . . to walk with it down that path, and is prepared to work in like fashion with the Court as well, so that this case enhances rather than impedes progress towards a business solution. Forcing a merger under the present circumstances will cause irreparable harm to both Dow and Rohm and Haas. Prudence dictates that the welfare of all legitimate stakeholders be considered and that a fair and a workable solution be found.”

Answer at pages 1-2.

“It [the merger between Dow and Rohm and Haas] was to be a merger made in heaven and for one very important reason — ‘synergy’ — that is easy to articulate but hugely difficult to execute successfully in practice. What’s required is the seamless combination of two very large and complex organizations into a community of people who work as one and will then build on their complementary strengths and resources to achieve a level of cooperation and performance that, if achieved, will produce huge new value.”

Answer ¶ 6.

“The Complaint misses the essence of Dow’s approach to the problems both Dow and Rohm and Haas face. Dow’s approach to this transaction is totally grounded in necessity. It is necessary first of all to get control of the basic building blocks of any future course by stabilizing credit ratings, obtaining workable financing and maintaining liquidity. Turning then to future action, the first order of business is to account and plan for uncertainties affecting Dow’s market, Rohm and Haas’s business, and the market for the merged entities. The overwhelming problem here is uncertainty. And it is unknown when and how those uncertainties will be resolved.”

Answer ¶ 38.

“Any forced merger at any time is an extreme, external intervention in a business process that can actually work only if it makes sense internally. It must be driven by the desires and goals of the people who go to work every day rather than by artificially (and hastily) imposed mandates. These basic human facts are all the more dominant where, as here, the merger depends upon the creation of new value through synergies.”

Answer ¶ 42 (emphasis in original).

By its answer Dow details the disasters that have been experienced by both Dow and Rohm and Haas with the crumbling economy, including the loss of business and substantial employee layoffs. Dow makes a reasonably convincing case that were it forced to merge with Rohm and Haas, it could quickly breach one or more covenants in the short-term debt financing it has secured to facilitate the merger, thus triggering cross-defaults in its other funded debt.

All of this triggers sympathy, but the obvious question is: so what? Dow does not claim a MAC permitting it to back out of the deal, nor does it assert that it could not secure the financing necessary to close (as Hexion asserted in its battle with Huntsman, that it decisively lost in Vice Chancellor Lamb’s court— see my prior posts on the Hexion v. Huntsman case).

The closest Dow comes to founding its answer (and refusal to close) on the July 10, 2008 merger agreement is the FTC’s antitrust clearance. Dow’s position is that the FTC order clearing the merger (which order requires certain divestitures by Dow) is not final and will not become so until after a 30-day comment period, and therefore this condition to the merger has not been satisfied. Answer at pages 24-26. This position seems contrary to the Commission order itself, which, in the FTC’s press release announcing it (also quoted in Rohm and Haas’ complaint) states that under the consent order the “transaction may proceed.” Moreover, the merger agreement itself does not require that any antitrust order be final, in the sense claimed by Dow, only that “[a]ny applicable waiting period under the HSR Act shall have expired or been earlier terminated, . . .” Merger Agreement § 6.1(c)(i). So even this defense appears to be a stretch. And even if it is valid, the order could very well become final by the end of February 2009, thus mooting this defense by the time the action is tried (scheduled for March 9, 2009).

Essentially Dow’s defense is that the merger won’t work and therefore the Chancery Court should not force its consummation. This position is expressed throughout Dow’s answer, often in language (including that cited above) that is jarring to the reader of legal prose:

“At bottom, these unforeseen and unforeseeable events have—for the time being—eradicated the essential purpose of this transaction: creating a viable merged organization, one that will combine tens of thousands of employees who must work together to create the synergies that made this acquisition make sense. Forcing them together in an over-leveraged, hobbled deal would do no equity to Dow, to Rohm and Haas, or to their employees, communities, customers and suppliers.”

Answer ¶ 49.

It is hard to believe that Chancellor Chandler will take Dow’s answer seriously. Dow’s plea for cosmic equity should fall on deaf ears. Chancellor Chandler is more likely to take the position that his role is to enforce a contract in a dispute brought by a party to that contract (Rohm and Haas), which party clearly has standing to allege a breach of the contract. While equitable considerations might be appropriate in the normal course, given the fact that the parties to this contract explicitly negotiated the provision (Section 8.5(a) of the merger agreement, quoted above) calling for specific performance in the event of breach, it is also hard to believe that the Chancellor will tarry long over the equities of enforcing the contract, should he find a breach.

Chancellor Chandler has scheduled trial in the case for March 9, 2009, rejecting Dow’s request for delay. Moreover, there are now press reports that Dow is shopping assets to provide funding to consummate the merger without tripping debt covenants, including the possible sale of one of its crown jewels, Dow AgroSciences. See the Deal Pipeline, February 6, 2009 (“Dow Considers Sale of Crown Jewel”).

So, in the unlikely event this case actually goes to trial, it will be of great interest to see how the Chancellor handles Dow’s plea for mercy.

County of York Employees Retirement Plan v. Merrill Lynch & Co., Inc.; Why Shareholder Litigation Inevitably Accompanies M&A Transactions

2008-12-31T08:41:00.000-08:00

By his letter opinion of October 28, 2008 (2008 WL 48253), Vice Chancellor Noble disposed of plaintiff’s motion for expedited discovery and defendants’ motion to stay or dismiss the action in favor of an action pending in the United States District Court for the Southern District of New York. I address in this post the Vice Chancellor’s disposition of the motion for expedited discovery, as it illustrates the virtual inevitability of confronting shareholder litigation in M&A transactions, certainly marquee ones such as this merger of Bank of America (“BAC”) and Merrill Lynch (“Merrill”).

A. Background

Much has been written about the fall of Lehman and the weekend negotiations that led to the announcement, on Monday, September 15, 2008, of the stock-for-stock merger of BAC and Merrill, see, e.g., Wall Street Journal, December 29, 2008 (“The Weekend That Wall Street Died,” page 1, column 3). Undoubtedly forests will fall in service of the books and studies that will be written in the years and decades ahead about these events and the housing and credit crises of 2008. In response to the announcement of the merger, shareholder actions were filed in the New York State Supreme Court, in the Delaware Chancery Court, and (by an amendment to a pending action) in the District Court for the Southern District of New York (the “Federal Derivative Action”).

In this Delaware action the plaintiff asserted that the directors of Merrill failed to satisfy their fiduciary duties, and challenged the adequacy of the disclosures set forth in BAC’s and Merrill’s joint proxy statement (as addressed by Vice Chancellor Noble, in preliminary form, as amended October 22, 2008). Plaintiff alleged that, having negotiated and agreed to the merger over a weekend, the directors failed to adequately inform themselves as to the true value of Merrill or the feasibility of securing an alternative transaction. Plaintiff also alleged self-dealing claims, particularly against John Thain, Merrill’s CEO and Chairman.

With respect to the merger agreement, plaintiff claimed that the Merrill board breached its fiduciary duties by its grant of an option to BAC to purchase 19.9% of Merrill’s outstanding shares at a price of $17.09 per share in the event that the merger were not approved by Merrill’s shareholders, and challenged the provision of the merger agreement requiring the board to submit the merger to Merrill’s shareholders even if the board elected to respond to a superior offer and withdraw their support of the BAC merger.

In its attack on the proxy statement, plaintiff alleged omissions of material information, including a failure to adequately describe the events leading up to the merger; insufficient information regarding the selection, compensation, and methodology utilized by Merrill’s financial advisor — its broker-dealer subsidiary; and inadequate disclosure concerning Thain’s negotiation of continuing employment while the merger negotiations with BAC were taking place.

B. Fiduciary Duty Claims

To justify expedited discovery, plaintiff must show good cause why expedited discovery is necessary, which in turn depends upon plaintiff’s articulating a “colorable” claim combined with a sufficient possibility of a threatened irreparable injury to justify imposing on the defendants the burden of expedited discovery and an expedited preliminary injunction proceeding. Letter Opinion (“LO”) at 14-15.

Because plaintiff failed to present a colorable claim that a majority of the Merrill board was self-interested and lacked independence, Vice Chancellor Noble applied the business judgment rule to plaintiff’s claims, rather than heightened scrutiny. Under Delaware’s business judgment rule, the board is presumed to act “with care and loyalty.” LO at 15.

1. Duty of Care Claims.

Not surprisingly, plaintiff alleged that, by approving the merger with BAC over a weekend the Merrill board breached its duty of care. But speed is not dispositive, observed the Vice Chancellor, and Delaware fiduciary law is contextual and can accommodate haste if justified by the circumstances:

“At their essence, these claims merely attack the speed with which the Merger was negotiated, drawing the conclusion that the Merrill board could not satisfactorily inform itself sufficient to justify business judgment rule protection over the course of a weekend. It is clear that ‘no single blueprint’ exists to satisfy a director’s duty of care. While such speed might be suspicious, it is not dispositive. Defendants justify their haste by claiming the existence of severe time-constraints and an impending crisis absent an immediate transaction. They argue that in light of these circumstances, the board exercises sufficiently informed judgment to dispose of their duty to make an informed decision. Such pressures may have existed, and our case law supports shaping fiduciary obligations to reflect such a reality. However, the contextual contours of the directors’ fiduciary obligations are fact driven; and the Court cannot undertake such a nuanced evaluation by way of an informal scheduling motion.”

LO at 17-18 (footnotes omitted).

So far, so good for the defendants. But they next run into a rough patch. The Vice Chancellor takes judicial notice, as defendants requested, of “well-known” market conditions, such as the subprime mortgage problems and the credit market and liquidity crises, but declined to accept as true, without further judicial examination, the facts of Merrill’s financial condition as set out in media reports and the proxy statement. “The interests of justice are served,” concluded the Vice Chancellor, “when such essential and critical facts [Merrill’s financial condition at the time the merger was negotiated] are properly developed in a manner recognized and accepted for establishing a factual basis for judicial action.” LO at 19. He articulates this touchstone:

“The need to consummate the deal within a matter of days, or even hours, was a business judgment, entitled to deference only if informed.”

LO at 20 (emphasis added).

Plaintiff alleged that the board’s business judgment in agreeing to the BAC merger was uninformed, and the Vice Chancellor concluded that plaintiff presented a colorable claim of such. “To hold otherwise,” concluded the Vice Chancellor, “would notice as fact the very essence of Defendants’ factual argument, and would allow inference and conjecture to serve as a factual record.” LO at 20.

2. Deal Protection Claims.

Defendants argued that each of the deal protection provisions attacked by plaintiff —the equity termination fee in the form of the stock option (capped at $2 billion, representing 4% of the value of the transaction), the “force-the-vote” provision; and the “no-talk” provision — have each been approved by the Delaware courts. The Vice Chancellor acknowledged the validity of this contention, LO at 21-22, but again resorted to context: “… deal protection devices must be viewed in the overall context; checking them off in isolation is not the proper methodology.” LO at 22. Because Merrill eschewed a pre-agreement market check, and conducted a truncated valuation of itself, plaintiff’s challenges to the deal protection claims were “colorable,” thus allowing plaintiff to proceed with expedited discovery.

3. Irreparable Harm

To proceed with expedited discovery, a plaintiff must allege irreparable harm. While plaintiff in this case did so in, as characterized by the Vice Chancellor, a “cursory” fashion, he concluded that plaintiff met the test: “Where, as here, damages that may be available are difficult to calculate and other uncertainties, such as collectibility exist, a sufficient showing of irreparable harm has been made to warrant expedition.” LO at 23 (footnote omitted).

C. Disclosure Claims

Disclosure claims are strategically important for shareholder plaintiffs, not only because, if meritorious, they necessarily involve irreparable harm; more importantly, they offer plaintiffs an opportunity for an early resolution and settlement of the case (and the award of counsel fees). By agreeing to make corrective disclosures, defendants offer plaintiffs “consideration” (non-monetary) to justify settlement of the case and the award of attorneys’ fees.

Plaintiff thus scored a considerable victory in Vice Chancellor Noble’s conclusion that its allegations regarding disclosures concerning the events leading up to the BAC/Merrill merger were colorable. Specifically, the Vice Chancellor concluded that the proxy statement’s failure to inform Merrill’s stockholders “what (if any) alternative structures to the [BAC] acquisition were discussed, and which (if any) potential acquirers, aside from BAC, Merrill’s board engaged in merger discussion with,” LO at 26-27, presented colorable disclosure claims. Merrill did disclose that it had entered into negotiations with “two other large financial services companies,” but did not disclose their identity. It is troublesome that the Vice Chancellor faulted Merrill for not disclosing the identities of these other companies — it is customary not to disclose the identity of suitors who do not make it to the altar. The Vice Chancellor also faulted Merrill for not disclosing the risks it faced if it failed to reach an agreement with BAC.

As to the other of plaintiff’s disclosure claims, the Vice Chancellor found them not to be colorable. These included plaintiff’s allegations regarding Merrill’s retention of its subsidiary, Merrill, Lynch, Pierce, Finner & Smith, its broker-dealer, to act as its financial advisor, and its purported failure to adequately disclose the negotiations BAC conducted with Thain about his continued employment with Merrill after the merger. The proxy statement, as amended, adequately disclosed the basis for Merrill’s retention of its affiliate (it had provided extensive financial and investment banking services to Merrill during the preceding two years) and adequately disclosed the conflicts presented by Merrill’s retention of its affiliate as its financial advisor.

Practice is mixed on the disclosure of the amount of compensation payable by merger parties to their financial advisors. Generally, amounts are not specified, unless the transaction is a going-private transaction or, upon review by the staff of the SEC, specific disclosure is required. In its initially-filed proxy statement, Merrill did not disclose the amount of the fee it agreed to pay its affiliate upon conclusion of the merger, just the fact that it agreed to compensate the affiliate contingent upon consummation of the merger. As observed by Vice Chancellor Noble, under Delaware law, “the precise amount of consideration need not be disclosed, and that simply stating that an advisor’s fees are partially contingent on the consummation of the transaction is appropriate.” LO at 33 (footnote omitted). Nevertheless, Merrill mooted the point by disclosing the fee in the amended proxy statement. The Vice Chancellor also concluded that there is no requirement under Delaware law for a party to disclose the precise methodology utilized by its financial advisor in its valuation, including disclosure of financial projections considered by Merrill’s or BAC’s financial advisors. The staff of the SEC will, however, require the disclosure of projections (typically as exhibits to Schedule 13E-3) utilized by financial advisors in going-private transactions.

The plaintiff faulted Merrill for not adequately disclosing the nature and substance of the discussions that occurred between BAC and Thain concerning his continued employment post-merger. But Merrill did disclose Thain’s (and the other executive officers’) financial interest in the transaction, including the details of their compensation packages. Such disclosure was adequate; defendants need not engage in “self-flagellating commentary”:

“The Plaintiff’s allegations of disclosure violations amount to nothing more than quibbles over the absence of self-flagellating commentary accompanying the compensation and employment disclosures. But, as discussed, the disclosures in the proxy and amended proxy sufficiently inform the shareholders of the Chairman’s interest in the transaction. It is well-established Delaware law ‘that to comport with its fiduciary duty to disclose all relevant material facts, a board is not required to engage in ‘self-flagellation’ and draw legal conclusions implicating itself in a breach of fiduciary duty from surrounding facts and circumstances prior to a formal adjudication of the matter.”

LO at 38 (citing Stroud v. Grace, 606 A.2d 75, 84 note 1 (Del. 1992)).

D. The Settlement

Not surprisingly, this litigation and the associated Federal Derivative Action (as to the merger) were settled within a month after the Vice Chancellor’s decision granting expedited discovery, and before the special meeting of the shareholders of BAC and Merrill called to approve the merger on December 5, 2008 (both companies’ shareholders did so). The parties entered into a Memorandum of Understanding (“MOU”) on November 21, 2008, filed with the Court and publicly disclosed by Merrill’s 8-K report of the same day. Also not surprisingly, the MOU focuses on corrective disclosures, both those set forth in Merrill’s October 22nd amended preliminary proxy statement, prompted, in part, by plaintiff’s complaint in this action, and the disclosures Merrill made in its November 21, 2008 8-K report, responsive to certain of plaintiff’s disclosure claims.

The MOU contemplates that the parties will negotiate and execute a definitive stipulation of settlement for presentation to and approval by the Delaware court. As part of that proceeding, plaintiff will seek an award of attorneys’ fees, the amount of which is to be negotiated between the parties or, failing agreement, by plaintiff’s petition to the Court. Thus will end this litigation. The path traveled is so well worn that one might almost conclude that a certain segment of the plaintiff’s bar specializing in challenging M&A transactions are an integral part of the deal teams.

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As he did in his ruling on defendants’ motion for summary judgment in Ryan v. Lyondell Chemical Company, 2008 WL 2923427 (July 29, 2008) (discussed in my posts of September 11 and 15, 2008), Vice Chancellor Noble demonstrates in this Letter Opinion an aversion to reaching definitive conclusions before he has before him a complete factual record developed after trial. In Ryan this reluctance proved fatal to defendants’ motion (which the Vice Chancellor denied); in this case, it served to permit plaintiff to proceed with expedited discovery. It was clear sailing after that.

TravelCenters of America LLC v. Brog (2008 WL 5272861, Del. Ch. Dec. 5, 2008); Snapping At One's Shareholders

2008-12-23T17:15:00.000-08:00

Shareholders of TravelCenters, a Delaware LLC, nominated two individuals for election to TravelCenters’ board of directors at the 2008 annual meeting. TravelCenters’ operating agreement sets forth detailed notice requirements for shareholders to follow in nominating candidates for the board, referred to by Chancellor Chandler as “hypertechnical.” Nevertheless, in a decision he handed down in April 2008, the Chancellor found that the shareholders’ notice did not comply with the operating agreement in several respects.

In a clear instance of “take this,” TravelCenters then sought recovery of over $1.5 million in attorneys’ fees and costs (Skadden represents TravelCenters) from the nominating shareholders! The basis of the request is section 10.3 of TravelCenters’ operating agreement:

“To the fullest extent permitted by law, each Shareholder will indemnify and hold harmless the Company (and any Subsidiaries or Affiliates thereof), from and against all costs, expenses, penalties, fines or other amounts, including, without limitation, reasonable attorneys’ and other professional fees, whether third party or internal, arising from such Shareholder’s breach of any provision of this Agreement or any Bylaws, . . . and shall pay such indemnitee such amounts on demand, together with interest on such amounts, which interest will accrue at the lesser of 15% per annum compounded and the maximum amount permitted by law, from the date such costs or the like are incurred until the receipt or repayment by the indemnitee.”

Slip Opinion at 3 note 8.

(This provision itself strikes this observer as overreaching (15% interest?), and should have put prospective shareholders on notice that this might be an investment to pass on.)

Chancellor Chandler sensibly rejected TravelCenters’ request for fee reimbursement. As he explained, there is a distinction between promises and conditions, with only a breach of the former constituting a breach of contract:

“Under principles of contract law, there is a distinction between promises and conditions. Promises give rise to a duty to perform, and conditions are events that must occur before a party is obligated to perform. While the non-performance of a promise or covenant can result in a breach of contract, the non-occurrence of a condition is not considered a breach unless the party promised that the condition would occur. Thus, unless a party was under a duty for a condition to occur, the nonperformance of a condition is not a breach of the agreement.”

Slip Opinion at 6 (footnotes omitted).

The nominating shareholders here violated a condition, not a covenant, and therefore did not breach TravelCenters’ operating agreement.

Moreover, concluded the Chancellor, his reading of the operating agreement comported with “common sense,” given that it defied belief, absent explicit language to the contrary, that TravelCenters’ shareholders had made a promise to be “personally liable” for millions of dollars for any failure to submit a proper notice to nominate directors.

Delaware, like most states, grants members of a LLC broad discretion to establish their rules of governance through the operating agreement. Accordingly, the Chancellor’s disposition of this dispute turned largely on contract interpretation. In a coporate context, undoubtedly public policy considerations would play a larger role, including the Delaware courts’ vigilance in policing measures that interfere with the effectiveness of a stockholder vote. See, e.g., Blasius Industries v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988).

What will be interesting is how the shareholders of TravelCenters react to this litigation: Will they head for the exits or redouble their efforts next year with a more careful eye to the notice requirements for nominating directors?

Hexion v. Huntsman; The Settlement

2008-12-18T09:51:00.000-08:00

The parties settled this litigation on Sunday, December 14. Hexion and various Apollo entities will pay Huntsman $1 billion in return for a settlement of all litigation between the parties and general releases. The early view of the settlement is that it is favorable to Hexion and Apollo, given the resounding defeat they suffered in the declaratory judgment action they filed in the Delaware Chancery Court, as reported in my post of October 7, 2008. As the Wall Street Journal reported in its “Heard on the Street” column of Monday, December 15:

“Huntsman is right to take the money. Legal processees are long, unpredictable affairs, and this is no time to be taking chances. Yet the outcome remains surprising. Apollo, having lost an important court ruling in September, had reason to sweat. That Huntsman’s market value dropped by 49% or $2 billion, Monday [December 15] – the difference between the $3 billion originally sought and the eventual settlement – suggests some of the investors expected a fight to the death.”

Actually, Hexion and Apollo faced damages of even greater than $3 billion, given that, after the Delaware Chancery Court’s decision, Hexion and Apollo were confronting “benefit of the bargain” damages to Huntsman for failure to pursue in good faith a consummation of the merger. As I pointed out in my post of October 29, 2008, reporting on Credit Suisse’s and Deutsche Bank’s decision not to fund the merger:

“Given that the per-share merger consideration is $28.00 in cash (plus 8%), that Huntsman has some 234 million (fully diluted) shares outstanding, and Huntsman’s shares closed on October 28 at $12.28, Hexion is facing potential damages to Huntsman of over $4 billion.”

Nevertheless, as they say, a bird in hand is worth two in the bush. The terms of the settlement are, as one would expect, favorable to Huntsman.

A. Terms of the Settlement

The $1 billion settlement payment comes from various sources:

· Hexion shall pay Huntsman the $325 million breakup fee pursuant to the terms of the July 2007 merger agreement with Huntsman;

· Certain unidentified Apollo entities shall purchase $250 million of 7% convertible notes of Huntsman;

· Unidentified Apollo entities shall pay Huntsman $200 million, in settlement of a counterclaim brought by Huntsman in the Delaware Chancery Court for “commercial disparagement;”

· Hexion and certain unidentified Apollo entities shall pay Huntsman $225 million, also in settlement of Huntsman’s commercial disparagement claim.

Why allocate $425 million of the $1 billion in settlement payments to the resolution of Huntsman’s “commercial disparagement” claim? (Vice Chancellor Lamb, in his decision in the case, concluded that Hexion had willfully violated its merger agreement with Huntsman (a contract violation) — he did not rule on Huntsman’s commercial disparagement counterclaim.) Presumably, this is done to qualify such payments for insurance coverage, although this is speculative on my part.

Hexion intends to fund the $325 million breakup fee by borrowing from Credit Suisse and Deutsche Bank under its existing commitment letter with the banks. In all events, at least $500 million of the settlement payments, including purchase of the convertible notes, is to be made by December 31, 2008, with the balance of the payments due and payable on or before March 31, 2009.

The settlement includes a commitment by the Apollo entities to provide financing to Hexion’s parent in the amount of $200 million (presumably to assist the parent in paying the breakup fee).

The settlement includes a resolution of all pending litigation between the parties and broad releases, conditional upon Hexion and Apollo’s payment in full of the consideration called for by the settlement agreement. Huntsman’s action against Credit Suisse and Deutsche Bank, pending in Texas state court, shall continue, with Hexion and Apollo agreeing to cooperate in the prosecution of that action. If Huntsman’s action against the banks is settled prior to trial, then Huntsman shall pay certain Apollo entities 20% of the settlement in excess of $500 million (after deduction for expenses, including attorneys’ fees), capped at a maximum payment to the Apollo parties not to exceed $425 million. If the case is tried, then Apollo’s interest disappears.

B. The Terms of the Convertible Notes

Affiliates of Apollo will purchase $250 million in convertible senior notes (the “Notes”) from Huntsman. The Notes shall be convertible, at the option of the holder, into shares of Huntsman common stock, initially at $7.86 (135% of the closing price of Huntsman’s common stock on December 10, 2008), subject to anti-dilution protection. The Notes bear interest at the rate of 7% per annum. Huntsman may pay interest either in cash or, at its option, in its common shares (at the then current value of the shares equal to the interest payment). The Notes are due and payable on the 10th anniversary of the issue date, in cash or, at the option of Huntsman, in its common shares at their then market price. The Notes are redeemable prior to their maturity for cash, at any time after the 3rd anniversary of the issue date. There is a one-year lock up period on the Notes during which they are not transferable without Huntsman’s consent to any party unaffiliated with Apollo.

Apollo agrees to broad voting and standstill protections for Huntsman, applicable to any transferee unless the Notes or the shares into which they are converted are broadly distributed or privately sold to persons who, after the sale, own less than 5% of Huntsman’s outstanding voting securities.

______________________
This settlement certainly removes an enormous cloud over Apollo and Hexion. It provides welcome cash benefits to Huntsman and leaves open the possibility of additional recoveries against Credit Suisse and Deutsche Bank. Attention will now, therefore, shift to Huntsman’s Texas state court action against the banks. Given that Apollo precipitated this entire mess by claiming that that the Hexion/Huntsman merger was untenable because the resulting entity would be insolvent, the banks must be fit to be tied at now being the sole remaining defendants in this litigation. If they cannot reach a quick and reasonable settlement with Huntsman, expect them to snarl with vigor at both Huntsman and Apollo in the Texas state court litigation.

Mervyn's LLC v. Lubert-Adler and Klaff Partners, LP; An Attack on the Use of Special Purpose Entities to Finance a Leveraged Buyout

2008-12-06T15:44:00.000-08:00

The complaint filed September 2, 2008 in the Delaware bankruptcy of Mervyn’s (Adversary Proceeding No. 08-51402-KG) represents a frontal attack on a strategy commonly employed in financing a leveraged buyout, namely, the use of special purpose entities to isolate the assets used to finance the buyout. Targets in this action include three buyout funds and their affiliates, Sun Capital Partners, Inc., Cerberus Capital Management, LP, and Lubert-Adler/Klaff Partners, LP. The lawsuit challenges the leveraged buyout of Mervyn’s LLC from Target (Symbol: “TGT”) on September 2, 2004. Ignoring the complicated minutiae of the deal structure, laid out ad nauseam in the complaint, the complaint makes for colorful reading. The defendants have yet to respond.

A. The Transaction

Mervyn’s was sold for all cash, in the amount of $1.175 billion. The form of the transaction was a “stock” purchase whereby Target sold all the equity of Mervyn’s, converted shortly before the closing from a California corporation to a California LLC, to a newly-organized Delaware LLC — Mervyn’s Holdings, LLC (“Mervyn’s Holdings”). In form, at least from Target’s standpoint, the transaction was straightforward, as is reflected in the plain vanilla Equity Purchase Agreement Target entered into with Mervyn’s Holdings on July 29, 2004. The complexity of the deal derives from how the buyers financed the acquisition. They did so in large part through $800 million in financing, secured by Mervyn’s real estate. To isolate the real estate, the complaint alleges that Mervyn’s Holdings, at closing, apparently contributed to its now wholly-owned subsidiary, Mervyn’s, the equity in two newly-organized LLCs, with the result that the newly-organized LLCs became subsidiaries of Mervyn’s. Mervyn’s, now as the parent of the newly contributed LLCs, in turn contributed to the LLCs (which, in turn, contributed several of the properties to subsidiary LLCs) its fee properties and transferable real property leases. Mervyn’s Holdings then caused Mervyn’s to distribute the equity interests in the LLCs to Mervyn’s Holdings, which in turn distributed the LLCs to LLC holding companies controlled by the buyers. Presto: The real estate formerly owned by Mervyn’s was now separated from Mervyn’s and owned by buyers through separate LLC holding companies.

The complaint further alleges that once Mervyn’s was separated from its real estate, the buyers caused Mervyn’s, now a lessee of its stores, to pay additional rent to the property owning LLCs to finance the purchase money indebtedness and to make distributions to the buyers. Mervyn’s was also charged “notional rent” on those leases that could not be transferred out of Mervyn’s (to bring the rent payable under these non-transferable leases to market) in the form of distributions to Mervyn’s Holdings. As a result, Mervyn’s rent burden, by these machinations, increased, according to the complaint, by some $80 million annually.

Since the buyout, the complaint alleges that the buyers “have taken more than $400,000,000 in payments or distributions from Mervyn’s.” Complaint ¶ 66 (footnote omitted).

As summarized by the complaint:

“73. In sum:
· Mervyn’s real estate assets were transferred from Mervyn’s to the Realty Owners [the separate LLCs form to own Mervyn’s real estate].
· The Realty Owners are owned and controlled by the Realty Parents [the real estate LLC holding companies].
· The Realty Parents are owned and controlled by the PE [private equity fund] Sponsors.
· The PE Sponsors own and control MH [Mervyn’s Holdings].
· MH owns and controls Mervyn’s.
· Mervyn’s was paid nothing for the transfer.”

As the complaint editorializes, reflecting on the complexity of the transfers that occurred at closing:

“These multiple transfers and transactions are complex machinations that seem to have no purpose or effect other than to attempt to secure the blatantly fraudulent transfer that occurred at the closing of the 2004 transaction.

… Mervyn’s began the day of the closing with more than $1,000,000,000 of real estate and, within the blink of an eye, it was gone. Mervyn’s received nothing in return.”

Complaint ¶¶ 75-76.

B. The Legal Attack

The debtors, Mervyn’s Holdings and its subsidiary, Mervyn’s LLC, bring this action against the buyers, their affiliated funds that participated in the buyout, the lenders that provided financing for the buyout, and Target. The complaint alleges that the stripping away of Mervyn’s real estate and the increase in its rental obligations deprived Mervyn’s of valuable assets, for no consideration, and significantly increased its operating costs. Moreover, by bundling properties that were previously owned in fee by Mervyn’s or separately rented into only three master leases, the deal made it more difficult for Mervyn’s to close stores, thus restricting its operating flexibility. As summarized by the complaint:

“Rather than simply maintaining Mervyn’s retail operations and the integrated real estate assets at which the retail stores were operated intact within Mervyn’s and leveraging the real estate assets as would have been done under a traditional LBO transaction, instead, the PE Sponsors insisted upon physically separating the real estate assets from Mervyn’s at the moment of the closing of the EPA thereby converting Mervyn’s from a retailer with valuable below market leases and valuable owned real estate into a shrunken operating company whose remaining capital consisted largely of inventory, cash, credit card receipts, and intellectual property.”

Complaint ¶ 93.

The debtors’ counsel, Friedman Kaplan Seiler & Adelman LLP, New York, New York, and Bayard, P.A. (Delaware) make interesting use of the legal opinion rendered by the property holding LLCs (the “Realty Owners”) to the buyout lenders. The opining counsel, not identified in the complaint, rendered a “true lease” opinion to the lenders on the three consolidated real estate leases entered into at closing between the (now separate) real estate holdings LLCs and Mervyn’s. The complaint quotes at length from the opinion to establish that the buyers were well aware of the economic aspects of the transaction and its consequences upon Mervyn’s. No doubt the extensive quotations from its opinion is causing opining counsel some discomfort (the quotations from the opinion occupy some five pages of the complaint).

To establish that the transfers of Mervyn’s real estate assets to the special purpose LLCs and their separation from Mervyn’s represented fraudulent transfers, the complaint alleges that Mervyn’s did not receive reasonably equivalent value or fair consideration in exchange for transferring its real property interests to the property holding LLCs. As a result, Mervyn’s, so the complaint alleges,

“… (a) was engaged or was about to engage in a business for which its remaining assets and/or capital were unreasonably small in relation to [its] business; (b) intended to incur, or reasonably should have believed that it would incur, debts beyond its ability to pay as they became due; and/or (c) was insolvent or would be rendered insolvent by the transactions undertaken in connection with the 2004 buyout.”

Complaint ¶ 109.

The debtors also allege that the transfers were in violation of the Uniform Fraudulent Transfer Act, violating at least six of the eleven factors to be considered in assessing a transfer as fraudulent under that Act. Complaint ¶ 112.

The debtors also allege breach of fiduciary duty, including against Target, asserting that, by reason of the buyout transaction, Mervyn’s became insolvent or entered the “zone of insolvency,” thus triggering fiduciary duties by Target to Mervyn’s unsecured creditors. Complaint ¶¶ 142, 151.

The debtors seek, by their prayer for relief, the avoidance of the real estate transfers made by Mervyn’s in the buyout or, alternatively, the value of the real estate assets transferred by Mervyn’s or, alternatively, an amount equal to the purchase price paid by buyers to Target for the real estate assets ($1,166,700,000) or the proceeds of the loan made by the lenders ($800,000,000).

This will be an interesting case to follow if it is not quickly settled. Given the nature of the allegations and the amount demanded as damages, a quick settlement would appear unlikely.

Exelon Corporation v. Cosgrove; Enlisting the Delaware Chancery Court to Play Matchmaker

2008-11-13T10:41:00.000-08:00

Exelon (NYSE: EXC) has launched an exchange offer for all of the outstanding shares of NRG Energy, Inc. (NYSE: NRG). Exelon is offering 0.485 of its common shares for each NRG share. The exchange offer follows a proposal made by Exelon to the NRG board on October 17. At that time, the exchange offer represented a 37% premium over NRG’s share price, albeit well below NRG’s 12-month high of $45 a share. NRG’s shares closed yesterday, November 12, at $21.60. Based upon yesterday’s closing price of Exelon ($50.57), the deal currently has a value of $24.53 per NRG share, down from a value of $26.43 on October 17.

Concurrently with its launch of the exchange offer, Exelon filed a complaint in the Delaware Chancery Court against NRG and its board of directors, seeking declaratory and injunctive relief. The basis for Exelon’s action is NRG’s rejection of Exelon’s October 17, 2008 deal proposal. NRG rejected the proposal by its letter dated November 9, 2008.

Exelon is miffed at the time NRG took to evaluate Exelon’s offer and reject it—20 whole days! It asserts by its complaint ((no. CA 4155) assigned to Vice Chancellor Lamb) that it has received “positive feedback” on its proposal “from a number of sources, including a number of NRG’s stockholders.” Complaint ¶ 3.

Exelon initiated discussions over a transaction with NRG on September 26, 2008, which was followed on September 30, 2008 by a meeting among the principals in New York. Apparently impatient at the slow pace of discussions, Exelon elected to make a formal proposal on October 19, 2008 and to publicly disclose it. Notwithstanding several attempts to engage in substantive discussions over the proposal with NRG, so Exelon asserts, NRG refused to do so. The rejection of Exelon’s proposal came in the form of NRG’s letter of November 9.

NRG has a somewhat different take on the matter, as detailed in its rejection letter. For present purposes, it is enough to note that NRG’s view is that Exelon’s proposal is “opportunistically timed” and “grossly undervalues NRG on both an absolute basis and relative to Exelon’s share value…” NRG’s CEO and Chairman point out to Exelon that, based upon the proposed fixed exchange ratio of 0.485, “NRG stockholders would own 17% of the combined company while contributing 30% of a combined company recurring cash flow in 2008.”

And, for good measure, Messrs. Crane and Cosgrove of NRG object to Exelon’s negotiating style, eschewing “private negotiation” and pursuing NRG “in a highly public and preemptive manner…” Since the proposal is for an exchange offer, Messrs. Crane and Cosgrove point out, for good measure, certain “risks and concerns” concerning Exelon as a company and as an investment by NRG’s stockholders.

Exelon’s Complaint.

By its complaint, Exelon asserts these claims:

· That NRG’s board’s rejection of Exelon’s proposal represents a breach of the board’s fiduciary duties to NRG stockholders, and will cause irreparable harm to Exelon and to NRG’s stockholders;

· The adoption of any defensive measure by the NRG board (including, for example, a poison pill) would itself be a breach of the NRG board’s fiduciary duties to NRG’s stockholders; and

· The NRG board’s anticipated refusal to render Section 203 of Delaware’s General Corporation Law (Delaware’s business combination statute) inapplicable to the Exelon proposal itself is a breach of the board’s fiduciary duties to NRG’s stockholders.

Exelon seeks, by way of relief, an order from the Chancery Court declaring that the board of directors of NRG has breached its fiduciary duties in rejecting Exelon’s proposal; declaring that the board’s failure to declare Section 203 inapplicable to the Exelon proposal is a breach of its fiduciary duties; compelling NRG to approve Exelon’s proposal for purposes of Section 203; declaring that the adoption of any measure which would thwart or frustrate Exelon’s proposal would be a breach of the board’s fiduciary duties; and enjoining NRG and its officers and agents from adopting any measure that would interfere or frustrate Exelon’s proposal.

The first question is whether Exelon has standing to assert fiduciary duty breaches against the NRG board. Generally companies such as NRG owe no fiduciary duties to takeover prospectors, and that would be true here, but for the fact that Exelon owns 500 shares of NRG common stock. While nominal, that should be sufficient to confer standing upon Exelon to assert its fiduciary duty claims against the NRG board:

“Delaware courts have shown considerable latitude in entertaining fiduciary duty litigation brought by stockholders who are also themselves bidders for control. The only consistent limitation placed on those persons is that they also be stockholders at all relevant times and, thus, among those to whom a duty was owed, even if they only own one share. Of course, this rule is not based on the economic significance of such a bidder’s investment, which often is immaterial. Instead, it is based on a purely legal or equitable notion that limits to those having a relationship with the corporation the right to sue over its internal affairs.”

Omnicare, Inc. v. NCS Healthcare, Inc. 809 A.2d 1163, 1172 (Del. Ch. 2002) (footnote omitted).

So standing should not be a barrier to the assertion by Exelon of its claims, but ripeness should be. Exelon’s claims are wildly premature. Undoubtedly they have been brought to open one front in what undoubtedly will be a long campaign between Exelon and NRG. The campaign includes not only Exelon’s exchange offer and this lawsuit, but also its threatened proxy contest for NRG’s scheduled 2009 annual meeting (May 14, 2009) at which Exelon has announced that it will seek to expand the size of NRG’s board such that the directors to be elected at that meeting will constitute not less than 50% of the NRG board, and will nominate candidates to fill the newly created vacancies.

That the campaign will be a long one is virtually assured by the nature of Exelon and NRG, heavily regulated power companies. Among other approvals for the deal listed by Exelon in its S-4 preliminary offering prospectus are approvals from the Federal Energy Regulatory Commission, the Nuclear Regulatory Commission, the Pennsylvania Public Utilities Commissions, the New York Public Service Commission, the California Energy Commission, the California Public Utilities Commission, and the Public Utility Commission of Texas.

So among those cheering this battle are Wall Street lawyers and bankers.

CSX v. TCI; Oral Argument Before the Second Circuit (August 25, 2008)

2008-11-11T15:10:00.000-08:00

The oral argument on the parties’ cross-appeals in this case was heard before judges Calabresi, Newman, and Winter on August 25, 2008. We are still awaiting the Court’s decision. As I reported in my post of September 15, 2008, the panel issued a summary order on September 15 affirming Judge Kaplan’s ruling not to enjoin the voting of CSX shares by TCI and 3G. The effect of that order was to seat four of the five nominees for the CSX board put forth by TCI and 3G. The panel’s explanation of its summary order, and its ruling on Judge Kaplan’s findings of liability and his entry of a permanent injunction restraining TCI and 3G from future violations of Section 13(d) of the Exchange Act will be addressed in its forthcoming opinion that fully disposes of the parties’ appeals.

I took the occasion over this past weekend to listen to a CD of the oral argument, as presented by Chris Landau of Kirkland & Ellis for TCI and 3G and by Rory Millson of Cravath for CSX. The argument was spirited, running for about an hour. The panel was clearly well prepared and peppered counsel with questions. Indeed, the exercise reinforced the observation that an effective litigator requires a steely determination and focus, since the last thing this panel allowed counsel to do was to complete a sentence. I am sure the transcript of the oral argument reads like Joyce’s Ulysses, with the beginning of a thought appearing on one page, the middle of the thought appearing many pages later, and the conclusion of the thought appearing somewhere near the end of the transcript.

While predicting the outcome of an appeal based upon a panel’s questions is hazardous, it struck this observer that Judge Winter had difficulty with CSX’s position and will therefore vote to overturn Judge Kaplan’s decision that, by entering into cash-settled equity swaps, TCI and 3G violated Section 13(d) of the Exchange Act. Judge Calabresi, who was the most active questioner (interrupter), and Judge Newman appeared more skeptical of TCI and 3G’s position, although by several of his questions Judge Calabresi expressed concern that Judge Kaplan’s findings of fact may not have been sufficient to serve as a predicate for a finding beneficial ownership by TCI and 3G in the CSX referenced shares.

By his questioning Judge Newman focused on the realities of the relationship between TCI and the banks. He directed Landau’s attention to the passage of Judge Kaplan’s decision where the Judge quotes from the SEC’s 1977 release adopting the beneficial ownership disclosure requirements:

“It therefore is not surprising that the SEC, at the very adoption of Rule 13d-3, stated that the determination of beneficial ownership under Rule 13d-3(a) requires

‘[a]n analysis of all relevant facts and circumstances in a particular situation … in order to identify each person possessing the requisite voting power or investment power. For example, for purposes of the rule, the mere possession of the legal right to vote securities under applicable state or other law … may not be determinative of who is a beneficial owner of such securities inasmuch as another person or persons may have the power whether legal, economic, or otherwise, to direct such voting.’”

Slip Opinion at 49-50 (citing to Exchange Act Release No. 34-13291) (footnote omitted, emphasis added).

What interested Judge Newman was the reference to “otherwise” in the quoted passage and what type of “otherwise” power the SEC was referring to. Given that counterparty banks are generally indifferent to the voting of any shares they may purchase to hedge their exposure to a swap, doesn’t the long party have “otherwise” power to direct the voting of such shares? In response Landau referred to the Division of Corporation Finance’s amicus letter to Judge Kaplan of June 4, 2008, in which the Division stated clearly that “economic incentives do not constitute a sufficient basis for establishing any such [voting or investment] powers.” Judge Newman appeared to dismiss the Division’s letter as not having the authority of an SEC release, such as the one he pressed Landau on. Judge Newman even posed this hypothetical to Millson, CSX’s counsel — what if TCI had asked Deutche Bank to vote the CSX shares and Deutche Bank had said, “Sure, we’ll vote with you.” (Apparently CSX did not have the opportunity to put that question to a representative of Deutche Bank.)

Millson, repeating the stance taken in CSX’s briefs, took the position that a long party who enters into a swap referencing more than 5% of an issuer’s shares, with the intent of exercising or influencing control of the issuer, is a beneficial owner of the referenced shares. The panel appeared clearly unreceptive to adopting this position. The panel pressed Millson on Judge Kaplan’s absence of any finding that TCI and 3G “influenced” the voting by its counterparties of their CSX shares. While Judge Kaplan concluded (Slip Opinion at 61) that there is “reason to believe that TCI was in a position to influence the counterparties, especially Deutche Bank, with respect to the exercise of their voting rights,” Millson had to concede that that was not a finding of influence.

Landau pressed the panel with TCI’s argument that Rule 13d-3 cannot extend beyond Section 13(d) of the Exchange Act and that a party must have “beneficial ownership” of shares before a reporting obligation under Section 13(d) arises. Judge Newman in particular appeared to have trouble with this claim, particularly in the context of the “plan or scheme” language of Rule 13d-(b), which extends “beneficial ownership” of shares to any “trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose or effect of … preventing the vesting of … beneficial ownership as part of a plan or scheme to evade the reporting requirements of Section 13(d) or 13(b) of the [Exchange] Act, …” (Emphasis added.) (The Division of Corporation Finance, in its amicus letter of June 4, 2008, stated its belief that Rule 13d‑3, “properly construed, is narrower in coverage than the statute.”) How, asked Judge Newman, can actual beneficial ownership be a predicate to a trigger for Section 13(d) reporting if the trigger includes arrangements or devices to “prevent” the vesting of beneficial ownership?

It is hard to say where this will come out. If I had to read the tea leaves, I would guess that Judge Calabresi would opt for sending the case back to Judge Kaplan for further findings, Judge Newman would affirm, and Judge Winter would reverse.

Or the panel, with judges Calabresi and Newman in the majority, could affirm Judge Kaplan’s finding of violation on grounds suggested by Professor Coffee, as discussed in my post of August 23, 2008:

“The ‘voting power’ prong [of Rule 13d-3(a)] has, however, greater promise. Most swaps dealers do not vote the shares they buy to hedge their position for a variety of reasons: because they have no economic motive to vote, because they fear losing Schedule 13G eligibility, or because it is more profitable to lend their shares to short sellers. Those that do vote often divide their votes, voting both ways according to some formula or according to the recommendations of a proxy advisory firm. Thus, the repeated act of recalling shares just prior to the record date and relending the shares immediately afterward does distinguish Deutsche Bank in this case from the vast majority of swaps dealers. A narrower decision, written on this rationale, could find a violation [of Schedule 13(d)] without generally deeming the ‘long’ side of an equity swap to be the beneficial owner of the referenced shares held by the dealer.”

Coffee, “The Wreck of the CSX: Transparency and Derivatives,” NY Law Journal (July 17, 2008).

For my prior commentary on this case, see my posts of September 15, August 23, 13, and 1, July 30, 26, and 17, and June 24 and 23.

Comet Systems, Inc. v. MIVA, Inc.; Are Change-of-Control Bonuses Properly Deductible in Calculating Earnout Payments?

2008-11-06T17:39:00.000-08:00

Comet was merged into a subsidiary of MIVA. The merger consideration consisted, in part, of a potential $10 million earnout, which could be earned over 2004 and 2005. The earnout was based upon Comet’s performance relative to three performance goals. One of the goals was a function in part of cost, defined in the merger agreement as “Operating Costs Excluding Amortization and One-time, Non-recurring Expenses.”

In anticipation of a potential transaction, Comet had adopted a bonus plan providing for the award of bonuses solely in the event of an acquisition or similar transaction. Under the plan, Comet paid out bonuses in connection with the MIVA merger, from the merger proceeds. MIVA deducted the payments as a cost in calculating the earnout, resulting in a reduced earnout payment.

A. The Bonuses Were Not A Proper Deduction

Vice Chancellor Lamb, in his opinion of October 22, 2008 (2008 WL 4661829), had little difficulty siding with the former stockholders of Comet in concluding that the “cost” of the merger bonuses was not an “operating cost” as defined in the merger agreement.

Delaware follows the “objective” theory of contracts whereby a contract’s construction should be that which would be understood by an objective, reasonable third party. The contract terms themselves are controlling when they establish the parties’ common meaning so that a reasonable person in the position of either party would have no expectation inconsistent with the contract language. Slip Opinion at 10-11, quoting Eagle Industries, Inc. v. DeVilbiss Healthcare, Inc., 702 A.2d 1228, 1232 (Del. 1997). MIVA argued that the merger bonuses qualified as an “ordinary” cost of doing business because they contribute to employee retention during a sales process. Responded Vice Chancellor Lamb:

“But the fact than an expense qualifies as an ordinary cost of business does not preclude treatment of that expense as one-time and non-recurring. Black’s Law Dictionary defines a ‘one-time charge’ as ‘[a]n ordinary cost of business excluded from income calculations.’ Thus, simply qualifying a cost as ordinary is not sufficient to dispositively determine that the cost is not one-time and non-recurring.”

Slip Opinion at 11.

The Vice Chancellor’s explanation of earnouts is instructive:

“Earnouts are typically used where the buyer and seller cannot agree on a price because the seller is more optimistic about the future prospects of a business than is the buyer. As a result, charges and costs which occur as a result of the merger and are not expected to be representative of future costs in the business are reasonably excluded. The natural reading ‘one-time, non-recurring expenses’ is to exclude exactly such charges.”

Slip Opinion at 11-12 (footnotes omitted).

B. Time For Performance

MIVA delayed an earnout payment it calculated was due, from March 2005 until June 2006. It argued that because there was no time specified for payment of any earnout amount in the merger agreement, the Court should not award interest on the amount due to the delay in its payment.

A specific payment covenant was not necessary, ruled the Vice Chancellor, because in every contract there is implied a promise or duty to perform with reasonable expediency the thing agreed to be done, and a failure to do so is a breach of contract. Slip Opinion at 18, citing Williston On Contracts. Therefore, MIVA had a duty to make the earnout payment within a “reasonable” time in the absence of a contractual term to the contrary. MIVA therefore should have made the payment within 90 days of its determination, and accordingly the plaintiff stockholders were entitled to interest on the overdue payment, notwithstanding the silence of the merger agreement on the time for payment.