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

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.

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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

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?

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?

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

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

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

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.