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.