A recent study by Cornerstone Research Inc. found that in 2011, more than 95% of mergers valued at $500 million or more prompted shareholder lawsuits. Given the abundance of companies with ample amounts of cash on hand, record-low interest rates and large number of undervalued firms waiting for buyers, many consider the current M&A market ripe for expansion. The question thus arises: What can boards of directors and deal counsel do to reduce the likelihood that a proposed merger will result in litigation?
There are certain common aspects of proposed mergers that are most likely to lead to litigation -- namely, (i) onerous deal protection devices, (ii) conflicts of interest and (iii) contingent and speculative deal consideration. While the possibility of litigation can never be wholly alleviated, there are certainly steps that a target board and deal counsel can take to reduce its likelihood.
The first focus for much of shareholder litigation -- deal protection devices -- is provisions to the merger agreement that are meant to protect the proposed acquirer from a competing bid. Obviously, the acquirer does not want to go through the process of due diligence, negotiations and drafting of the merger documents only to have the target board use that as leverage to go out and find a better deal. The flip side is the target board does not want to be precluded from getting a better deal if it turns out another company is willing to pay more. Delaware courts have upheld the use of deal protection devices even if they discourage other bidders so long as they are reasonable and not tantamount to a complete barrier to entry. If a target board agrees to deal protections that collectively appear to "lock up" the target from competing bids, however, then shareholder litigation is bound to follow.
The most commonly used but potentially problematic of deal protection devices are no-shop provisions, matching rights, excessive termination fees and voting agreements. A no-shop provision means just what is says -- it prohibits the target board from going out into the market and shopping the company for higher offers once a definitive merger agreement has been executed. No-shop provisions must, at least under Delaware law, contain a "fiduciary out" that will typically permit the target board to respond to unsolicited competing bids that it reasonably believes will lead to a "superior proposal" -- as defined in the merger agreement.
The safer course of action for a target board is to insist that the merger agreement contain a go-shop provision. A go-shop provision allows the target company to actively seek, discuss and negotiate an alternative transaction with a third party for a specified period of time, usually 30 to 60 days, after the execution of the merger agreement. To provide protection from litigation, however, the go-shop must be more than window dressing and must actually allow for an active canvass of the market to seek out any potential higher bidders.
In the event that a competing bidder emerges and makes an offer to acquire the target, a deal protection device known as matching rights requires the target to provide the initial bidder with a specific number of days to match the new offer. While eliminating matching rights in their entirety would be ideal from a shareholder's perspective -- as doing so would maximize the possibility of a competing bid emerging -- the target board should at least negotiate to place a cap on the number of times that the initial bidder can match a competing bid.
The next deal protection device, the termination fee, comes into play when the target company fails to consummate the merger for any number of reasons. In almost every merger agreement, the target board agrees to pay a fee to the acquirer if a superior proposal comes along. Theoretically, this is to compensate the acquirer for the time and expense incurred in reaching the original agreement. Frequently, though, the reality is that the termination fee is used to deter another bidder since any higher offer would have to first cover the termination fee. To prevent or discourage litigation, the parties to a merger agreement should agree on a reasonable termination fee.
Delaware courts have generally found termination fees constituting 3% to 4% of the transaction value to be permissible. As such, termination fees rarely fall below this range. However, the parties should consider lower termination fees that may appear more reasonable to a would-be plaintiff, while at the same time accomplishing the termination fee's intended purpose of deterring the target from walking away from the deal. Additionally, a low termination fee in conjunction with a go-shop demonstrates that the target is sincere in its efforts to attract a higher bidder.
One additional problematic provision that acts as a deal protection device is the voting agreement. This is a contract between certain (usually substantial) shareholders and the acquirer, in which the shareholder parties to the agreement agree to vote their shares in favor of the proposed merger. In order to actually give shareholders a voice in whether to approve or reject a merger, the acquirer should avoid entering into such voting agreements with significant target shareholders.
The most troublesome mergers involve some sort of conflict of interest that calls into questions the motivations of the parties involved. Conflicts of interest generally present themselves in two forms. The first type of conflict arises when a controlling shareholder or member of senior management will benefit from the merger in a manner not shared by the target company's shareholders in general. The second type of conflict occurs when a financial adviser with an interest in the transaction on the acquiring side is simultaneously advising the target on the financial fairness of the proposed merger. In re El Paso Corp. Shareholder Litigation, In re Del Monte Foods Co. Shareholders Litigation and In re Delphi Financial Group Inc. Shareholder Litigation are recent examples of cases where conflicts were at the heart of the dispute. Either type of conflict is problematic, as the conflicted party is incentivized to support the merger agreement for reasons not necessarily in the best interests of the target company's shareholders.
In the event of a conflicted target company controlling shareholder or member of senior management, the target board should, at the very least, wall off the conflicted party from the deal negotiations.
A better practice is for the target board to establish a special committee of independent directors -- directors with no financial or personal ties to the interested party that inhibit their ability to act independently -- to negotiate the deal.
Of course, in order for a special committee to have its desired effect, the special committee must actually negotiate, not merely act as a figurehead for the interested party.
In addition, when a shareholder controls more than 50% of the target company's shares entitled to vote, it is critical that the target board ensure that the merger agreement contain a majority-of-the-minority provision. Instead of a mere majority vote, a majority-of-the-minority provision requires shareholder approval of the deal by a majority of the target company's unaffiliated shareholders.
It is equally imperative that the financial adviser who will be rendering an opinion on the financial fairness of the merger has no improper motivations, so that the target company's shareholders have an unbiased opinion on the merger price on which to base their vote. The presence of a conflicted financial adviser can prove to be extremely costly to all parties in a potential merger.
The form of the deal consideration itself can also lead to litigation. Occasionally, the parties to a merger agreement will structure the deal such that a portion of the consideration paid to the target shareholders is in the form of a contingent value right.
A CVR is a derivative whose value is tied to future events, such as product performance or revenue targets. If the event occurs, the CVR holder can collect, but if the milestone is not reached, the holder gets nothing. Shareholders challenging a CVR will argue that the CVR is worth zero, as it is nothing more than a contingent right to potentially receive some additional value in the future.
Even if something is ultimately paid in accordance with a CVR, the time value of money necessarily means it is worth less than if the same consideration were received as part of the original merger. Accordingly, CVRs should be structured as additional -- not substitute -- consideration to the target company's shareholders in order to provide value certainty.
The threat of litigation in connection with a proposed merger can never be entirely eliminated. However, by taking steps to ensure a fair and open bidding process, providing shareholders with a meaningful vote on the proposed merger and compensating shareholders fairly, boards of directors and deal counsel can significantly reduce the possibility of litigation.