Prof. Amitai Aviram University of Illinois College of Law

Mergers & acquisitions, Chapter 2 (Business Associations, Chapter 5) Dealmaking & dealbreaking
Prof. Amitai Aviram University of Illinois College of Law Copyright © Amitai Aviram. All Rights Reserved S15

Dealmaking & dealbreaking (MA2/BA5) Chapter overview
Acquisition basics Share acquisition mechanics Structural acquisition mechanics The M&A dance M&A litigation Crafting acquisition agreements

Acquisition mechanics How can Y acquire X?
Control can be transferred / consolidated by: Proxy solicitation (no changes to X or to ownership of X’s shares) We studied this in Section 1b Not actually an M&A technique, because the transfer of control is temporary When is this technique useful? When isn’t it? Share acquisition methods (no changes to X itself) Market share acquisition Bilateral share acquisition Tender offer Structural acquisition methods (changes to X itself) Long-form merger (“LFM”) Short-form merger (“SFM”) Asset sale (considered an M&A technique when all of a firm’s assets are sold; if only specified assets in a firm are sold, an asset sale does not transfer control, but is a viable alternative to M&A in acquiring assets)

Acquisition mechanics Share acquisition methods
Y buys X’s shares from XS, until Y accumulates enough shares to control X Market share acquisition: Y buys X shares on the stock exchange Bilateral share acquisition: Y negotiates with individual XS to purchase X shares Tender offer: Y makes public offer to XS to buy their shares Does Y care if others know that its purchases are for M&A purposes rather than investment purposes? In which case (bilateral vs. market) are others more likely to know? Which of these options is most convenient if Y wants to purchase a lot of shares?

Acquisition mechanics Share acquisition methods
Example: Y wants to acquire control of X Y is worth $400; X is worth $100 Each has 100 shares outstanding; neither currently owns other’s shares Y offers to buy 100 X shares at $1 per share In a market share acquisition, Y’s broker places orders for 100 shares on the stock exchange, while the current shareholders place orders with their brokers to sell those share (so no one knows who their counterparty is) In a bilateral share acquisition, Y buys the 100 shares in face to face deals with the current share owners In a tender offer, Y publicly offers to buy 100 X shares at $1/share XS sell all 100 shares; Y pays $100; X becomes Y’s wholly-owned subsidiary

Acquisition mechanics Structural acquisition methods
Merger example Y signs a merger agreement with X, under which X & Y will merge, with Y surviving the merger. Under the agreement: YS receive 1 share in merged (new) Y for each pre-merger (old) Y share they own XS receive $1 for every X share they own The boards of X and Y approve the agreement The SHs of X and Y approve the agreement X and Y file (with Delaware Secretary of State) Articles of Merger Result: Y consists of businesses of both former Y & former X, minus $100 paid to XS XS received $100 YS own the merged Y; X ceases to exist Asset sale example Y pays X $100 in return for all of X’s assets X is now an empty shell with $100 in cash X dissolves, distributing $1 to each XS

Share acquisition mechanics Skirting pitfalls in tender offers
Too many shares tendered Y can’t afford / doesn’t want all of X’s shares Solution: Y makes a tender offer for a certain # of shares (less than 100%) Too few shares tendered Y is stuck as a MSH in X Solution: Y conditions tender offer so that Y is obligated to purchase only if a minimum # of shares (e.g., 51%) were tendered Not all shares tendered Y has to deal with MSHs in X Solution: freezeout merger to ‘cash-out’ MSHs Why not condition tender offer on being offered 100% of shares?

Share acquisition mechanics Williams Act
Share acquisitions are regulated under federal law by the Williams Act (1968 amendments to §§ of the Exchange Act) Apply only to registered securities The Williams Act regulates: Disclosure of share holdings Disclosure in tender offers Rules regarding the tender offer process

Share acquisition mechanics Disclosure of share holdings
Beneficial owner of 5% of a registered security must file a disclosure (Schedule 13D) within 10 days of crossing the 5% threshold [§13(d)(1)] 5% threshold includes aggregate purchases by several people as part of a single plan [§13(d)(3)] Passive filers (who do not seek control of the issuer) may file a (shorter) Schedule 13G Schedule 13D filing includes: Identity of Y Number/class of shares owned Plans / intentions (including an intention to seek control of the issuer) Any contracts, arrangements, understandings or relationships with respect to the securities of the issuer Board-supremacy supporters (e.g., Delaware Chief Justice Strine) push to shorten reporting deadline (to 24 hours) & to reduce ownership threshold (to 2%)

Share acquisition mechanics Disclosure of share holdings
Changes in holdings: Schedule 13D must be amended promptly in the event of any material change in the facts set forth in the statement (Rule 13d-2) Acquisition/disposition of at least 1% of a class of securities is material Enforcement: X can sue a 5% beneficial owner for failing to file a Schedule 13D or for filing a misleading statement Has standing to seek equitable relief (injunction, rescission of securities purchases, divestiture of the securities, suspension of voting rights), but not damages

Share acquisition mechanics Disclosure/process of tender offers
Rules triggered when a tender offer is made for more than 5% of X’s equity securities An offer commences when the bidder provides security holders with means to tender their securities A transmittal form; or Information regarding how the transmittal form may be obtained Bidder may communicate intent to acquire shares without commencing the tender offer if communication does not include means to tender the securities, and all written communications re tender offer are publicly filed [Rule 14d-2(b)]

Share acquisition mechanics Disclosure in tender offers
By the date tender offer commences, Y must file a Schedule 14D-1 disclosure statement Same info must be disseminated to SH via newspaper publication or mailing XB must then file a Schedule 14D-9 form, in which the management states, with reasons, whether they: Support the offer Oppose it Are unable to take a position

Share acquisition mechanics Process of tender offers
Tender offer must be open for at least 20 biz days [Rule 14e-1(a)] If Y changes amount of shares acquired or price offered, offer must be open for 10 biz days after change [Rule 14e-1(b)] If tender is over-subscribed (i.e., more shares are tendered than Y offered to purchase), Y must accept shares on a pro-rata basis [§14(d)(6)] Any Y who raises his price during the term of the tender offer must raise it for any shares already tendered [§14(d)(7)]

Acquisition basics Share acquisition mechanics Structural acquisition mechanics The M&A dance M&A litigation Crafting acquisition agreements

Structural acquisition mechanics Procedure of a LFM
Parties sign a merger agreement Board approval of merger agreement (each party) [DGCL §251(b)] SH approval of merger agreement (each party) [DGCL §251(c)] Approval by majority of shares entitled to vote No vote required (subject to some conditions) in mergers preceded by tender offer, after which Y owns enough shares to approve the merger [DGCL §251(h)] Filing [DGCL §251(c)] Merger becomes effective when Articles of Merger are filed At that point, all merging parties cease to exist except for one surviving entity; all property & liabilities of merging parties vest in/attach to surviving entity [DGCL §259(a)] Appraisal [DGCL §262] SH who opposed the merger (but lost) may petition the court to determine the fair price to be paid to them (rather than accept the price Y offered) DGCL §262(h): Appraisal value is the fair value “exclusive of any element of value arising from the accomplishment or expectation of the merger…” Why do we have appraisal rights?

Structural acquisition mechanics Procedure of a SFM
Y notifies all other SHs that it is merging with X in a SFM, specify the terms of the merger & provide all info material to a decision whether to seek appraisal Only allowed if Y owns ≥90% of X’s shares Filing Merger becomes effective when owner files a certificate of merger (certifying that Y owns ≥90% of X’s shares & that Y’s board approved a SFM Appraisal [DGCL §262] Any MSH may petition the court to determine the fair price to be paid to them Statutory authority DGCL §253 allows SFM with corporation DGCL §267 (2010 amendment) allows SFM with non-corporate entities (partnerships, LLCs, and other unincorporated associations)

Structural acquisition mechanics Procedure of an asset sale
Parties sign an asset sale agreement Buyer receives all of seller’s assets, pays seller agreed consideration Board approval of agreement (each party) SH approval of agreement (seller only) [DGCL §271] Required if seller is selling “all or substantially all of its property and assets” Approval by majority of shares entitled to vote Seller dissolves, giving its SHs the consideration it received Appraisal rights to seller’s SHs (in some jurisdictions; e.g., MBCA) DGCL does not provide appraisal rights to SHs of seller

Structural acquisition mechanics Differences between merger & asset sale
Tax consequences [advantage merger] Merger may be structured as tax-free reorganizations Asset sale has tax consequences for X/Y. Also, when empty shell of X is dissolved (to give XS the cash/stock received for X’s assets), this has tax consequences for XS. Complexity of transferring control [advantage merger] Merger: title to all properties is automatically vested in the surviving firm by operation of law Asset sale: each asset must be transferred separately (e.g., deed of transfer needs to be filed in every county in which X has real-estate) Transfer of liabilities (e.g., hidden liabilities) [advantage asset sale] Merger: surviving firm assumes all merging firms’ liabilities Asset sale: liability isn’t transferred (exceptions discussed in Section 2c2) Approval/appraisal [advantage asset sale] Merger: requires SH approval by & invokes appraisal rights for both XS & YS Asset sale: requires approval of both XB & XS, but only board approval on Y’s (buyer’s) side; no appraisal under DGCL

Structural acquisition mechanics Triangular merger
Mergers generally require SH approval of both parties, and create appraisal rights for SHs of both parties However, a form of merger called a triangular merger allows Y to bypass these SH rights The trick: Y forms S, and S merges with X S’s SHs get voting & appraisal rights, but S has just one SH: Y, which is controlled by YB (who supports the deal) Called triangular merger because there are three parties: Y, S, X

Y forms S S is capitalized with the consideration to be paid to XS S merges with X, paying XS Before Merger Step 1: Y forms S Acquirer (Y) XS Acquirer (Y) 100% Consideration to XS Target (X) Subsidiary (S) Step 2: S has a cash-out merger with X After the Merger Acquirer (Y) XS Acquirer (Y) XS 100% 100% Consideration to XS Subsidiary (S) Subsidiary (S) [including Target] Target (X)

Triangular mergers combine advantages of mergers & asset sales Tax consequences & complexity of transferring control may be similar to a merger S’s limited liability (subject to PCV) shields Y from X’s liabilities like an asset acquisition would XS vote & get appraisal rights, but YS get neither Y is the only SH in S, and YB (not YS) controls how Y votes

Forward triangular merger – S is the surviving entity Reverse triangular merger – X is the surviving entity Acquirer (Y) Acquirer (Y) Target (X) Subsidiary (S) Subsidiary (S) Acquirer (Y) Acquirer (Y) Target (X) Subsidiary (S) Target (X)

Structural acquisition mechanics Appraisal rights
To be entitled to appraisal rights: SH must perfect his appraisal right by sending a written notice to the firm prior to the SH vote, informing that he intends to exercise his appraisal rights [DGCL §262(d)] SH must not vote in favor of merger, consent to it in writing or accept the benefits of the transaction SH must hold shares continuously through merger’s effective day No appraisal rights if both: stock is publicly traded or held by over 2,000 SHs [DGCL §262(b)(1)]; and the consideration to the SH is publicly held stock [DGCL §262(b)(2)] No class procedure for appraisal rights Why is this important? A can manage appraisal risk by having a condition in the merger agreement that allows A to abandon the merger if more than a certain # of SHs demand appraisal (or if less than a certain # of SHs approve the merger)

Structural acquisition mechanics Remedies for faulty mergers
Berger v. Pubco Corp. [Del. Ch. ’08, S.Ct. ‘09] Berger is a MSH in Pubco; Kanner owns >90% of Pubco Kanner transfers Pubco shares to Pubco Acquisition, Inc. (“PAI”), then executes a short-form Kanner sends notice of merger to MSHs, but includes very little financial info & an outdated copy of appraisal statute Berger sues Kanner for breach of fiduciary duty of disclosure, demanding the fair value of his shares (an appraisal) SHs have appraisal rights in a SFM. Why does Berger need to allege a breach of FD? Note the distinction between appraisal rights & an appraisal remedy

FD of disclosure is breached only if misrepresentation or omission is material Test for materiality of an omission: Substantial likelihood that disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of info made available Info doesn’t need to be necessary to reach the decision

Did Kanner breach duty of disclosure? Outdated statute Court: explicit statutory requirement is always material No explanation for how Kanner set the $20 price Kanner: Not material since there’s no duty to set a fair price Court: It is material since it affects SH’s decision whether $20 is a fair price or SH should seek appraisal No details of products or services Pubco offered Court: Not material; irrelevant to SH’s decision whether to seek appraisal No explanation for what company intended to do with its cash Court: Plaintiff noticed that company has $36 of cash/share – suggests appraisal is sensible; no need for additional info Kanner is liable, but what’s the remedy?

Structural acquisition mechanics Remedies for faulty LFMs
Remedy for breach of FD in a LFM is usually limited to appraisal (receiving the fair value of plaintiff’s shares) Reason: if merger was approved by majority of SHs, plaintiff did not have the power to block the merger, and shouldn’t get this power as a remedy However, in cases of fraud, misrepresentation & corporate waste other remedies are available, such as rescission of the merger or rescissory damages I.e., keep shares in firm or receive value as if firm didn’t merge When would rescissory damages exceed an appraisal?

Structural acquisition mechanics Remedies for faulty SFMs
Glassman (Del. 2001): appraisal is exclusive remedy for a faulty SFM SFM doesn’t require SH consent & takes effect before the disclosure takes place, so SHs couldn’t rescind merger even if A acted legally The appraisal remedy requires SH to formally demand appraisal (i.e., opt-in) and to remit shares & entire merger consideration Glassman has 3 exceptions: fraud, illegality & inadequate disclosure. Case didn’t say what remedy applies then. Gilliland (Del.Ch. 2004): “quasi-appraisal” SHs must opt-in & must place in escrow (not give to firm) a portion (not all) of merger consideration In Berger, Del.Ch. adopts this remedy; Del. Reverses (so Gilliland is not longer valid law) Berger (Del. 2009): (also) “quasi-appraisal” SHs automatically in (may opt-out) & don’t need to place any money in escrow

Structural acquisition mechanics Remedies for faulty SFMs
Why do Del. Ch. & Del. disagree? Del.Ch. in Berger: Without escrow requirement, SHs risk nothing; get appraised value if higher than merger consideration, otherwise keep merger consideration Del. in Berger: With escrow requirement, deceiving controller risks nothing; if MSHs win suit, they get same appraisal rights they had anyway

Acquisition basics Share acquisition mechanics Structural acquisition mechanics The M&A dance Y decides terms of offer Y’s calculus Compensation composition (acquisition finance) Friendly approach Why would XB resist? Entrenchment Long-term plans Holding out for a better offer Hostile approach M&A litigation Crafting acquisition agreements

Y decides terms of offer Y’s calculus
M&A is a complex game between YB, XB & XS Y + XB alliance: friendly deal (one that is supported by XB) Y + XS alliance: hostile deal (a transaction that doesn’t require XB‘s approval) XB + XS alliance: no deal Y decides what to offer based on: Value of X to Y Alternatives, for X & for Y, to doing the deal Support for Y among XS Strength of takeover defenses

Y decides terms of offer Support for Y among XS
Likely enemies: XS who are unlikely to sell to Y E.g., shares held by directors/officers, SHs supportive of board, index funds Likely allies: XS who are likely to sell to Y E.g., SHs who must sell now; disgruntled SHs; merger arbitrageurs (arbs) Arbs are investors who identify companies that they expect will be taken over, buy shares, and sell to premium. Example: X’s shares sell for $10; Y makes $15, but XB resists Market believes 80% chance board will succeed in blocking deal (& no chance better deal will come up), so shares sell for $11 Anna the arb believes Y will succeed. She Typically arbs use mostly borrowed money to leverage the “bet” Arbs’ purchases gradually push price up, deterring long-term investors Y succeeds: Anna sells to (+$4); Y fails: price drops to $10, Anna sells (-$1) Playing the Arb card The larger the number of shares held by arbs, the more likely Y succeeds Arbs pile in if they believe the Y will succeed, so it’s a self-fulfilling prophecy: if Y persuades arbs it will succeed, Arbs buy more shares, making Y’s success more likely Because they use borrowed money, arbs lose interest if it looks like takeover contest will take time

Y decides terms of offer Strength of takeover defenses
Takeover defenses analysis Which defenses does X have in place or XB can implement without SH approval? Why does Y focus on defenses that don’t require SH approval? Section 2b2 will address takeover defenses Strength of legal challenge to existing & expected defenses Section 2b3 will address legal challenges to takeover defenses Y offers terms aimed to ally with one of the other parties Hostile approach (ally with XS) if Y has strong XS support & takeover defenses are weak, or if a friendly approach failed: appeal to XS via price & compensation composition Otherwise, friendly approach (ally with XB): appeal to XB via golden parachutes or positions in the merged firm

Y decides terms of offer Compensation composition: what do XS get?
Cash XS prefer this (complete certainty about compensation), but it reduces Y’s cash Variation: leveraged buyout (LBO) – borrow the cash used to pay XS (increases Y’s debt & financing must be secured before acquisition is done) Variation: paying with Y’s bonds (increases Y’s debt & adds uncertainty to XS) Shares XS receive uncertain value; dilutes Y’s SHs Requires approval by the SH meeting if: Newly issued shares will exceed authorized # of shares (under DGCL); or X listed on NYSE or NASDAQ & shares issued increase the # of outstanding shares by more than 20% (under NYSE/NASDAQ listing rules) Popular when Y’s stock price is high; not popular when Y has a controller Assuming X’s debt Increases Y’s debt X’s creditors benefit, not XS; why would XS tolerate this form of compensation?

Y decides terms of offer Compensation composition: financing an LBO
If Y borrows money to acquire X (an LBO), Y wants to: Pay as little interest as possible; and Isolate Y’s other businesses from the acquisition (i.e., if X fails, Y does not want creditors to take Y’s other assets) Solution: have X assume the loan, or use X’s assets as collateral Can Y do that before it owns 100% of X? To address this problem, structure of LBO financing is often: Bridge financing: creditor lends to Y for short time & at high interest rate (at same time, parties may agree on terms of long-term loan (step 3)) Y uses bridge financing to pay XS for 100% of X Once Y owns 100% of X, Y either: Negotiates long-term loan using X’s assets as collateral (lower interest rate) Causes X to take a long-term loan & transfer the money to Y as dividend (Either way, Y uses new money to repay the bridge financing)

Friendly approach The "love letter"
Y usually prefers a friendly acquisition if possible Overcoming X’s takeover defenses is costly & sometimes impossible Hostile deal alienates X’s management & risks managers quitting if Y succeeds Some institutional investors that finance acquisitions refuse to participate in hostile deals Y sends XB a “love letter” Usually a private message with a non-threatening tone Outlines proposal & price, invites XB to negotiate Y hopes this will lead to private talks with XB and ultimately to agreement on a friendly acquisition

Friendly approach Less friendly approach: “bear hug”
A more aggressive approach than a “love letter” is for Y to send XB a (public) “bear hug” letter (see MSFT 8-K, 2/1/08) Love us: praise synergies of proposed deal Fear us: suggest that Y may go hostile Fear your SHs: hint at FD breach if X refuses XB rejects A’s “bear hug” offer “Soft” rejection: typically emphasizes that board deliberated, consulted with advisors & found that Y’s offer significantly undervalued X “Hard” rejection: objects to fundamental aspects of Y’s proposed deal (e.g., Y’s plans for X, ability to finance the deal or get regulatory approval) Harder for XB to later accept improved offer from Y, but gives XB broader grounds to reject Why is a rejection so likely?

Friendly approach Due diligence
Y reviews X’s records to determine interest in deal/X’s value This presents risks to X Y may use info to compete with X, sell it to X’s rivals, or insider trade Y may use info to launch a hostile acquisition (posing as a friendly acquirer to get info, then going hostile, is called a “Lady Macbeth strategy”) To address these risks, Y is typically required to sign Confidentiality agreement Limits who sees info; Y promises not to sell info, poach employees, etc. SEC Rule 10b5-2: illegal to trade on info when person agrees to maintain info in confidence (addresses insider trading risk) Standstill agreement Y agrees, for a period of time, not to acquire X’s shares without XB’s permission

Friendly approach Selecting an acquirer
Option 1: Auction (simultaneous negotiations with multiple Ys) XB asks potential acquirers for firm (i.e., binding) offers following preliminary due diligence Y can sometimes “soften” the firmness of the offer by adding conditions Depending on predetermined auction format, XB may: Pick the best offer & finalize the agreement with them Have additional rounds of bidding Option 2: Bilateral negotiation followed by “shopping” the agreement Instead of simultaneous negotiations, X may sign an agreement with Y then use it as leverage to get Y2 to negotiate a better deal (“shopping” the agreement) Sometimes XB is interested in a deal with Y, if no better deal is “shopped”; other times Y is just used to set a minimum price, and the goal is to sell at a higher price to some other acquirer (Y is then called the “stalking horse”) Why would Y agree to be a stalking horse? When would XB want to use a stalking horse?

Friendly approach Letter of intent
Signed by both sides’ representatives, contains the issues that have been agreed upon thus far Letter of intent (“LoI”) is sometimes called a Memorandum of Understanding or a Term Sheet Enforceability: usually parties don’t want LOI to be a binding contract Why sign an LOI if parties don’t want it to be binding? Common (alternative) terms addressing enforceability LOI is subject to the execution of a definitive agreement LOI only memorializes preliminary understandings & is not intended to be binding on either party Survivability LoI states what obligations are enforceable even if deal collapses (confidentiality, writing requirement)

Friendly approach Definitive acquisition agreement & beyond
Content of acquisition agreements discussed in Section 2b3 Typically, Y does more thorough due diligence while final details of the acquisition agreement are negotiated Why not do all due diligence in step 1? Progressing towards closing XB “shops” for better offers Y secures financing (if not done earlier) Approvals: from regulators, SHs, etc. (as needed)

Why would XB resist? Entrenchment
XB resists either because they think Y will fire them, or they want to force Y to give them a side-payment to allow the deal to go through Side payment is in the form of a golden parachute If this is XB’s motivation, it’s not in XS‘s interest Why not just outlaw golden parachutes?

Why would XB resist? Long-term plans
Allow contrarian, innovative strategies (but also inefficient ones) Example XB wants to invest in developing solar-powered cars (eco-friendly but slower & more expensive than gas-powered cars) XB anticipates that concern for the environment & higher gas prices will increase demand for solar cars in a decade It wants X to be the leader in solar cars at that point The market’s common wisdom is that solar cars will never be profitable, so when X undertakes the investment, its stock price drops This makes X more susceptible to takeovers Y could buy X at the depressed price, ditch the solar cars & profit from the rebound in X’s price XB hopes to maintain the strategy until the market realizes its wisdom

Why would XB resist? Holding out for a better offer
XB resists to force Y to offer a better price – which is in XS’s interest Example X’s shares $10/share; Y values $20/share Y offers XB a cash-out merger for $15/share If XB can prevent Y from acquiring then Y has the choice between walking away (profit: 0), or making a better offer, say, $19/share (profit: $1/share) The delay may also give Y2 time to make a bid, creating competition that drives up the price Why do XS need XB to hold out for a better offer? Can’t XS hold out? Reason: when no SH currently controls X, Y can play XS against each other & acquire control without paying a control premium Example: Suppose that X’s shares are trading for $10/share, but are worth $20/share to Y

Y offers to buy 51% of X in tender (“front end”) To encourage SHs to tender, Y announces that if tender offer succeeds & Y gains control of X, it will merge X with Y’s wholly-owned subsidiary, cashing out remaining X SHs for $10/share (“back end”) This is known as a two-tier front-loaded tender offer Alternative back end: instead of a $10/share merger at the back end, Y can announce plans to manage X so that the value of economic rights is reduced to $10/share E.g., no dividends, reinvest profits in very long-term investments or currently unpopular investments

XS expect that if Y fails, its rival Y2 will buy X for $20/share Or that if Y fails to Y will improve the offer to $20/share What would a XS do if she could coordinate with all other XS (or if she owned all of X’s shares)? What would a XS do if she couldn’t coordinate with other SHs? Each XS faces the following possible outcomes: SH tenders the stock & tender offer succeeds: SH receives $15/share for at least 51% of her stock (more, if total # of shares tendered is <100%), and $10/share for the rest ($12.55/share if 100% tender) SH does not tender the stock but tender offer succeeds: SH receives $10/share for all of her stock Tender offer fails: It doesn’t matter if SH tendered; Y2 buys shares from SH for $20/share (or Y improves offer to $20/share)

The decision tree Tender succeeds $12.55-$15/share SH tenders Tender fails $20/share Tender fails $20/share SH does not tender Tender succeeds $10/share

MSH’s decision tree Tender succeeds $12.55-$15/share Better SH tenders Tender fails $20/share Same Tender fails $20/share SH does not tender Worse Tender succeeds $10/share

Controller’s decision tree Tender succeeds $12.55/share SH tenders Tender fails $20/share Tender fails $20/share SH does not tender Tender succeeds $10/share

Hostile approach Paths to going hostile
XB is against deal but most of XS support it If XS are also against, the deal isn’t happening… Two paths to going hostile Proxy contest to gain control of XB, then engage in friendly merger or asset sale Hostile share acquisition to gain control of XB (often followed by a freezeout via merger or asset sale) Y will pick path with the fewest defenses (or may try both)

Hostile approach Path 1: proxy contest
How? Elect insurgent slate of annual SH meeting Call special meeting or create a written consent that either – Removes existing directors (without cause) & fills vacancies Expands board size & fills vacancies If Y wins control of XB : back to a friendly acquisition Likely a merger or asset sale (to avoid SH hold-outs)

Hostile approach Path 2: hostile share acquisition
Y needs an acquisition technique that doesn’t require approval by XB Stock acquisition (not merger or asset sale, which require XB approval) Typically Y wants 100% of X, so it then needs to freeze out MSHs Via merger or asset sale (once Y has control of X) Two-tier tender offer Step 1: Y takes control of XB via stock acquisition Step 2: Y cashes out remaining XS in friendly deal via SFM (if ≥90%), LFM or asset sale If PStep1>PStep2 offer is front-loaded; if PStep1<PStep2 offer is back-loaded

Hostile approach The remainder of the M&A dance
Y & XB try to gain leverage over each other Both Y & XB lobby major XS XB deploys/enhances takeover defenses Y tries to overcome the takeover defenses Pushing through despite the defenses Suing XB to force them to dismantle the defenses Defects in procedural or substantive authority Breach of board’s FD in implementing the defenses Replacing XB & having new XB dismantle the defenses Endgame Y & XB agree on a friendly deal Y goes ahead with the tender offer Y gives up on the deal

Acquisition basics M&A litigation Takeover defenses FD in the M&A context Crafting acquisition agreements

Takeover defenses Common takeover defenses
Takeover defenses reduce Y’s ability to acquire X without support of XB (even if XS support Y) Appealing to XS PR Leveraged recapitalization White knight Reduce XS influence on X’s behavior Voting plans Staggered board Reduce SH control of the SH meeting agenda Specific constraints on acquisition mechanics Contingent rights Poison pills Lock-ups

Takeover defenses Appealing to SHs: PR & Leveraged recapitalization
Goal is to reduce # of shares in “weak hands” (SHs likely to sell to Y) Arbs & other short-term investors SHs who think XB can’t increase X’s value above Y’s offer PR campaign aims to persuade SHs that: Y’s takeover attempt will fail (so arbs don’t buy shares) X will be worth more in the future than Y’s offer X will take steps that dissenting SHs like: Make corporate governance changes Pay dividends or repurchase shares Sell or spin-off unattractive operations Leveraged recapitalization X borrows money & eliminates assets (unattractive operations/excessive cash) X distributes this money to XS (usually via share repurchase) Effects Raises share price (increases cost of share acquisition & makes XS happier) Takes shares away from weak hands Makes X less attractive target for LBO (less cash & more debt)

Takeover defenses Appealing to SHs: White knight
XB gets potential acquirer (Y2) to offer a more attractive offer than Y, and signs an acquisition agreement selling X to Y2 Variation of this is a “white squire”: Y2 (who supports XB) buys a minority position in X, thwarting majority SH support for Y’s bid Purchases of X’s stock by X’s Employee Stock Ownership Plan (ESOP) has the effect of a white squire XB can encourage Y2 to make a more attractive offer by – Preferential access to info about X (XB allows Y2 to conduct due diligence), resulting in Y2 having more certainty than Y regarding X’s value “Lock-ups” in the acquisition agreement (terms that shift value from X to Y2 if Y2 does not acquire X)

Takeover defenses Reduce XS influence: Voting plans
Limiting voting rights of large SHs Early US corporations (& some modern co-ops) had a “one SH, one vote” rule Providence & Worcester Co. v. Baker [Del. 1977]: One vote per share for the first 50 shares, then one vote per 20 shares for all shares over 50 Société Générale voting rights capped at 15%, unless the SH owns >50% Limiting voting rights of new SHs (“tenure voting plan”) E.g., in France, the Florange Act doubles voting rights of registered SHs who held shares >2 years Supermajority voting provision E.g., charter provision requiring SH vote on merger/asset sale to be approved by a ⅔ or ¾ majority (rather than simple majority of shares entitled to vote) Loss of controller voting power SHs owning more than certain % lose their voting rights unless MSHs vote to reinstate the rights (this rule is sometimes imposed by statute, but not in Del.)

Takeover defenses Reduce XS influence: Staggered boards
DGCL §141(d) allows charter/bylaws to create a staggered board Staggered board as a takeover defense Takes longer to control XB (which is necessary to approve structural acquisition methods, dismantle takeover defenses, or distribute dividends to allow Y to repay debt incurred to acquire X) Defeating a staggered board Patience Bylaw amendment to de-stagger board (doesn’t work if charter provision staggers the board) Bylaw amendment to increase board size & appoint new directors (doesn’t work if charter limits board size) Note: if board is staggered, DGCL 141(k)(1) prevents de-staggering via SH removal of directors (default: director removal only for cause)

Takeover defenses Reduce XS influence: SH control of agenda
Bylaw/charter clauses that limit SH agenda control reduce Y’s ability to replace XB Advance notice bylaw can limit SHs ability to affect agenda of the annual SH meeting (e.g., advance notice requirement, share ownership requirement) Deny SHs the ability to call a special meeting (default: no such ability) Deny SHs the ability to act by written consent (default: SH have this ability) Limit SH ability to remove directors without cause DGCL 141(k) limits removal in staggered boards & cumulative voting Limit SH ability to expand board size E.g., charter says board size is determined by board resolution Limit proxy access (default: none required) Limit expense reimbursement (default: at board’s discretion)

Takeover defenses Specific constraints on acquisition mechanics
Profit disgorgement rules Y must repay profits on shares sold within [#] years after acquisition This rule is sometimes imposed by statute, but not in Delaware Business combination statutes [DGCL §203] Y is prohibited from having a “business combination” with X for 3 years after Y owns 15% or more of X Delays the back end (freezeout) of an acquisition Delays refinancing Y’s bridge loan in an LBO Exceptions Y has 85%+ interest in X (not counting shares owned by XB/officers/ESOPs) Prior approval by XB Subsequent approval by XB + 2/3 majority of disinterested SHs (written consent not allowed)

Takeover defenses Specific constraints on M&A mechanics
Opting out of DGCL §203 Original charter rejects application of DGCL §203 Subsequent opt-out via charter or SH bylaw amendment by majority of shares entitled to vote (usually only effective after 12 months) DGCL §203 doesn’t apply to close corporations (no shares listed & fewer than 2,000 SHs), unless The interested SH caused the corporation to “go private”; or Charter specifically adopts DGCL §203 Y’s options for addressing DGCL §203 (if X has that defense) Friendly deal (must have XB waive defense before Y owns 15%) Patience (acquire control of X, then wait 3 years for freezeout) Acquire over 85% interest (excluding shares of directors/officers/ESOPs) Acquire control of X, replace XB, have new board waive defense & have ⅔ of disinterested XS approve waiver in a SH meeting Proxy contest to have XS amend bylaw to opt out of §203 (then wait 12 months for this to become effective)

Takeover defenses Contingent rights: Poison pills
“Poison pills” are contingent rights given to XS or T (third party), which if exercised make takeover less feasible Called poison pill because the contingent rights typically shift value from X to another party (XS or T) if they are triggered; i.e., they “poison” X if Y acquires it Elements of a poison pill Poison: contingent rights that reduce takeover feasibility Usually, Y & S are excluded from exercising the right Vehicle: legal instrument that contains the contingent rights E.g., contract, bond, share A common vehicle is “blank-check preferred shares” (charter states that terms of these shares will be determined by board prior to issuing them) Until triggered, rights can’t be sold separately from vehicle. Why? When triggered, rights detach from vehicle & can be exercised or traded Trigger: event that allows exercising the contingent rights Antidote: a way for XB to dismantle the defense E.g., until triggered, rights can be waived by XB or redeemed by XB for a nominal price. Why allow XB to waive/redeem the rights?

Takeover defenses Contingent rights: flip-over plans
The first poison pills became known as “flip-over” plans Effective against freezeout mergers Vehicle: equity securities (e.g., blank-check preferred shares) Trigger: executing a freezeout merger Poison: right to purchase common stock of the merged firm (either Y or S, merged with X) at below market price How can X cause S (controlled by Y) to issue shares? Antidote: usually, shares are redeemable by board for a nominal amount (e.g., 1¢) Result of activating pill: X SHs dilute Y/S’s pre-existing SHs

Takeover defenses Contingent rights: example of a flip-over plan
X (100 outstanding shares) executes a flip-over poison pill Charter allows board to determine the rights & limitations of the preferred shares, and board determines (in a Certificate of Designation) the following: Poison: if someone merges with X, each preferred share gives its SH (other than Y) the right to buy 3 shares of the firm that survives the 10% of market price Antidote: XB may redeem untriggered preferred shares for 1¢/share XS receive a dividend of 1 preferred share for each common share they own Y acquires 60 X shares in tender offer, then freezes out remaining 40 X shares by merging X into S (Y owns all 100 of S’s outstanding shares) Executing the freezeout triggers the rights SHs owning the remaining 40 X shares exercise rights (a bargain at 10% of market price) & receive 120 S shares Y now owns 100 of the merged S’s 220 shares, or 45%, losing control of S to TS Weakness of flip-over plans: Y can acquire control of X but not execute a freezeout, in which case poison pill doesn’t trigger

Takeover defenses Contingent rights: flip-in plans
Effective against share acquisitions Similar to flip-over plans, except: Trigger: exceeding a certain share ownership threshold (rather than freezeout) Poison: right to purchase shares in X (rather than in S) Example: X (100 outstanding shares) executes a flip-in poison pill XS receive 1 preferred share for each X common share they own Poison: If anyone acquires >30 shares, each preferred share gives its SH (other than Y) the right to buy 2 X 10% of market price Y acquires 60 shares (60%), triggering the poison Owners of remaining 40 shares exercise rights, receiving 80 new shares Y now owns 60 of 180 shares (33%); to control X, Y needs to buy more shares Why must Y be excluded for the pill to work? Under Unocal, unequal treatment of SHs is acceptable if reasonably related to the threat that board is defending against

Takeover defenses Contingent rights: back-end plans
Vehicle: equity securities (e.g., blank-check preferred shares) Trigger: executing a freezeout Poison: XS may convert X’s shares into X’s bonds Bonds can include terms (covenants) that make it difficult to shift bridge financing to X (see “poison debt” in a later slide) This sets a minimum price for the acquisition Y has to offer higher back-end price (if Y offers a freezeout price lower than the value of the bonds, SHs will convert & receive the bonds) Higher back-end requires Y to also offer a higher front-end

Takeover defenses Contingent rights: example of a back-end plan
X implements a back-end plan, which when triggered (upon a freezeout merger) allows SHs to convert each X share into a $20 bond Bond has covenant that prohibits X from selling any major assets or using them as collateral, until the debt is paid Y wants to acquire X for $16/share, but no one will tender shares at that price, since they can wait & get a $20 bond instead Y executes a tender offer for 60% of shares at $20, planning to cash out the remaining 40% at $10 Average price Y plans to pay is $16 [.6x x10] Y plans to finance purchase by selling X’s widget division After Y buys 60 X shares, it executes a freezeout $10 XS convert shares into $20 bonds ($20 bond > $10 in cash) Y now controls 100% of X, but effectively paid $20 per share Until it pays the debt it cannot use X’s assets to finance the tender offer Y is better off simply offering $20 on the back end as well They pay $20/share anyway, but won’t have restrictive bond covenants

Takeover defenses Contingent rights: poison debt
Vehicle: debt securities Trigger: change of control (“CoC”) – covers various method to change control of the firm Poison: vehicle includes terms (covenants) that make it difficult to shift Y’s bridge financing to X Forbidding X from assuming additional debt Forbidding X from selling/mortgaging its assets Restricting ability to distribute dividends Macaroni defense: upon change of control, X must redeem bonds at premium price (e.g., 200% of face value) Called macaroni defense because debt expands like macaroni Antidote: XB allowed to waive covenants or redeem debt (before CoC occurs) for a nominal price What business justification can you give for such covenants besides takeover defense?

Takeover defenses Contingent rights: poison contracts
Vehicle: contract with a third party (e.g., employees) Trigger: CoC Poison: transfer of value from X to third party Examples In response to a Microsoft bid, Yahoo! implemented a CoC severance plan for all of its employees Upon termination wo/cause after a CoC, an employee will receive severance equal to up to two years’ base salary & his/her options will accelerate (vest immediately) What business justification can you give for such clauses besides takeover defense?

Takeover defenses Contingent rights: lock-ups
Lock-ups are “poison contracts” intended to attract a white knight’s bid Termination fee X pays Y2 specified liquidated damages if X terminates acquisition agreement So if Y acquires X, X has to pay damages to Y2 reducing X’s value to Y “Crown jewels” provision Allows Y2 to acquire (at an attractive price) assets of X that Y particularly wants, if X terminates acquisition agreement Shifts value from X to Y2 like a termination fee, plus possibly eliminating the reason Y wants to acquire X Similar defense: when Microsoft bid for Yahoo (wanting to consolidate search engines to counter Google), Yahoo negotiated with Google a joint venture providing Google with control of Yahoo’s search operations

Acquisition basics M&A litigation Takeover defenses FD in the M&A context Crafting acquisition agreements

FD in the M&A context Invalidating takeover defenses
Defects in procedural or substantive authority Fiduciary duties: same analysis as any board/controller FD challenge Challenges to board behavior: framework in Section 1a1 (e.g., Van Gorkom) Challenges to controller behavior: framework in Section 1a3 (e.g., Kahn) Special rules for XB’s FD analysis in the M&A context When XB deploys corporate power against XS to achieve greater good for the firm (e.g., by deploying takeover defenses), use enhanced scrutiny SoR rather than BJR (Unocal) Revlon test determines when the “greater good for the firm” may include long-term goals Recall the three reasons for the board taking defensive actions Holding out for a better offer: good for XS Entrenchment: bad for XS (and breaches FD) Long-term plans: may or may not be good for XS When Revlon applies, board must maximize short-term SH wealth

FD in the M&A context Unocal analysis
When does enhanced scrutiny apply? Enhanced scrutiny applies when the board deploys corporate power against SHs to achieve greater good for the firm Interference in SH voting (Blasius) Board implements takeover defenses (Unocal) Board implements poison pill designed to prevent any SH from owning >15%, to preserve tax advantages for firm (Selectica [Del. 2010]) Board embarks on a transaction that will result in a change of control (Revlon) The Unocal test (applying enhanced scrutiny to takeover defenses) Did the board find, in good faith & after a reasonable investigation, that the firm faced a threat that warranted the defensive action? Was the defensive action a reasonable response proportionate to the threat posed?

Did the board find, in good faith & after a reasonable investigation, that the firm faced a threat that warranted the defensive action? Good faith: Self-dealing & bad faith analysis (similar to BJR) Reasonable investigation: negligence analysis (similar to BJR) Purpose/threat: what constitutes a legitimate threat? [Airgas, Del. Ch. 2011] Structural coercion (e.g., 2-tier front-loaded tender offer) Opportunity loss: offer preempts other offers that are better for SHs Substantive coercion: essentially, a price that the board deems inadequate (justification: subject to Revlon, board gets to choose long-term plans) Losing the “corporate culture” as result of takeover may be an acceptable threat (Paramount)

Was defensive action a reasonable response proportionate to the threat posed? Unitrin [Del. 1995]: presumed unreasonable if coercive/preclusive Coercive: “[A]ctions which have the effect of causing [SHs] to vote in favor of the proposed transaction for some reason other than the merits of that transaction” [Williams v. Geier, Del. 1996] Preclusive: making an acquisition by Y realistically unattainable Selectica [Del. 2010]: preclusive if Y’s ability to wage a successful proxy contest & gain control is realistically unattainable; but a combo of staggered board + poison pill is not inherently preclusive Airgas [Del. Ch. 2011]: defense is not preclusive as long as election process (proxy contests) would allow bidder to get the deal done Evaluate threat-response proportionality even if response is not coercive or preclusive

FD in the M&A context Defenses that cannot be dismantled?
A defense with an “antidote” (mechanism allowing XB to dismantle the defense) is vulnerable to a proxy contest in which XS replace XB with directors who support Y’s offer, who then dismantle the defenses to allow the deal Defenses that can’t be dismantled have been invalidated “No hand” poison pills: Defenses cannot be undone by board (Quickturn: invalid because it constrains board’s plenary authority under §141(a) without being in the charter) “Dead hand” poison pills: Only current directors can dismantle defense (Carmody: invalid as preclusive under 2nd prong of Unocal)

FD in the M&A context What are Revlon duties?
When Revlon applies: Subsequent board actions are analyzed under the heightened standard of reasonableness (enhanced scrutiny), not BJR Did the board find, in good faith & after a reasonable investigation, that the firm’s interests warranted the challenged action? Was the challenged action a reasonable way to achieve that interest? Board must act to maximize SHs’ short-term wealth Absent Revlon, board can choose whether to maximize SH wealth in short-term (e.g., sell X for best price available now) or in long-term (e.g., not sell X until its strategy bears fruit) When Revlon applies, board must act to maximize wealth in short-term (e.g., takeover defenses allowed only if they increase the expected offer to XS)

FD in the M&A context What are Revlon duties?
“No single blueprint” that XB must follow Process needs to be a reasonably way to achieve the interest, not necessarily the best way the court would have picked Need to pick offer that’s best for XS in short-term, but not necessarily highest price Example: In re Dollar Thrifty [Del. Ch. 2010] Dollar Thrifty signed deal to be acquired by Hertz for $41/share; Avis then offered $46.50 Dollar Thrifty concluded that Avis deal was more likely to be blocked by antitrust agency, and rejected it SHs sue, claiming Dollar Thrifty should have negotiated with Avis in order to draw it & Hertz into a bidding war Court: Revlon only requires the board to adopt “a reasonable choice [to maximizing sale value] that a loyal & careful board could adopt in the circumstances.” XB’s actions complied with Revlon duties.

FD in the M&A context When does Revlon apply?
Revlon applies 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” [Lyondell Chem. Co. v. Ryan, Del. 2009] Policy: Revlon duties are designed to capture for X’s current SHs the value of the control premium in the firm Even if XB is correct about long-term plans, current XS gain nothing from those plans if they are cashed out today (before long-term plans materialize) So, if no control is transferred, no control premium is at stake & Revlon duties do not apply

FD in the M&A context When does Revlon apply?
When does Revlon not apply? Board does not support a sale (“just say no” defense) Board decision not to sell T analyzed under BJR But if board negotiates with Y1, it has “embarked on a transaction… that will result in [CoC]”, so Revlon applies Stock transaction that does not create change of control Paramount v. QVC [Del. 1994]: If X currently has no controller (“[control is] vested in the fluid aggregation of unaffiliated stockholders”), then CoC occurs (& Revlon applies) if transaction results in a controller, but not if after transaction T still has no controller (e.g., XS get shares in Y & after deal Y has no controller) But when XS receive cash, Revlon applies even if merged company has no controller, because XS will not have future opportunity to get control premium In re Smurfit-Stone Container Corp. Shareholder Litigation [Del.Ch. 2011]: Revlon applies in a 50% cash / 50% stock transaction, even if merged company has no controller (for 50% of each X SH’s investment “there is no tomorrow”)

M&A litigation Revlon as a review
Pantry Pride offers to acquire Revlon for $40-45/share Revlon was then trading at about $40 Revlon rejects Pantry pride’s offer & implements takeover defenses Stock repurchase (leveraged restructuring) Note Purchase Rights Plan (“Rights”) (variant of back end poison pill) Trigger: anyone obtaining 20% of Revlon stock, unless offer for all Revlon shares is ≥$65/share Poison: when triggered, SHs may exchange their shares for $65 notes payable in one year & bearing a 12% interest Plan’s effect: if everyone acts rationally, how many shares would be converted into notes under this plan? Antidote: Rights can be redeemed by Revlon’s board for 10¢

Pantry Pride’s move (hostile tender offer) Pantry Pride announces a tender $47.50/share Offer contingent on: (a) 90% of the stock tendered; (b) Revlon’s redemption of the Rights Can the tender offer succeed at this price? Why make it? Revlon’s move (leveraged restructuring + poison debt) Revlon exchanged Senior Subordinated Notes (“Notes”) + preferred stock for ⅓ of Revlon’s common stock Causes Revlon to incur an additional $475M debt Notes contain covenants limiting Revlon’s ability to take debt, sell assets or pay dividends (unless waived by independent directors) What does use of poison debt add? Pantry Pride’s move (reducing tender offer price) First cuts price from $47.50 to $42, but as Revlon seeks other acquirers, Pantry Pride raises price to $53, then $56.25

Revlon’s move (“white knight”) Plans a leveraged management buyout, organized & financed by Forstmann Little (an investment bank) To shift debt to Revlon, board was will waive covenants in the Notes Note-holders objected, since waiving the covenants lowers notes’ value Why is the board vulnerable if it waives covenants? Revlon management exits deal; Forstmann Little remains a bidder for Revlon Pantry Pride’s move (topping Forstmann’s offer in several rounds of bidding) Revlon’s move (“white knight” with lock-ups) Acquisition agreement with Forstmann that includes the following lock-ups: “Crown jewels”: If A2 acquires 40% of Revlon, Forstmann has option to purchase two key Revlon divisions for $525M ($ M below valuation) Termination fee of $25M No-shop provision To deal with covenants, Forstmann will replace the Notes with new notes Pantry Pride sues to enjoin takeover defenses

Flaws Alleged FD breach for implementing initial defenses (Rights & stock repurchase) Alleged FD breach for implementing later defenses (lock-ups) Duty: yes – Revlon’s board owes Revlon & its SHs a FD as directors SoR Stock repurchase likely assessed under BJR (power not deployed against SHs) Rights & lock-ups deploy corporate power against SHs (preventing SHs from selling their shares to Pantry Pride), so enhanced scrutiny applies Also, for lock-ups, enhanced scrutiny applies because board embarked on deal to sell control of Revlon to Forstmann Application – Rights Quasi-BJR Board acted in good faith & conducted a reasonable investigation Purpose: Pantry Pride’s offer was too low (in Revlon board’s opinion) & directors preferred to hold out for a better offer. Revlon duty does not apply, since board has not yet embarked on a transaction that will result in a change of control), so this threat is legitimate Reasonableness Defenses do not coerce SHs, nor do they completely preclude a takeover; they’re reasonable Application – Lock-ups Same as Rights, except for the ‘purpose’ element. Now Revlon duties do apply, since board agreed to sell the firm to Forstmann. So board is now required to maximize the sale price (by encouraging the bidding contest between Forstmann & Pantry Pride). The later defenses thwart Pantry Pride’s offer, ending the bidding contest – therefore purpose is improper & FD was breached.

Acquisition basics M&A litigation Crafting acquisition agreements Document structure Contracting around the law Contracting around other contracts Dealing with interlopers Dealing with adverse change

Document structure Elements of the acquisition agreement
Representations & warranties (“reps”): factual claims (by either party) addressing situation pre-signing Separate sections for representations & warranties of X and those of S/Y Remedy – if rep is materially incorrect: Condition is usually triggered, allowing the other party an “out” When X isn’t publicly owned, Y often also entitled to indemnification from sellers (XS). Why isn’t this done when T is a public firm? Covenants: promises as to post-signing but pre-closing period Affirmative covenant – promise to take specified action Negative covenant – promise not to take specified action Financial covenant – promise to: maintain certain level of financial performance; or not take action unless certain level of financial performance exists at that time

Document structure Elements of the acquisition agreement
Conditions: circumstances that have to occur for the parties to have to perform (failing to satisfy a condition gives a party an “out”) Satisfying regulatory requirements Material adverse change (MAC) Financing condition (Y has “out” if it can’t secure financing for the deal) Representations & warranties materially correct Termination: circumstances that allow a party an “out” Breach by other party “Fiduciary out” (“out” if superior offer materializes) Failure to satisfy conditions by specified (“drop dead”) date

Document structure Addressing issues in the acquisition agreement
Known legal issues Contracting around the law (form vs. substance) Contracting around other contracts (navigating change of control clauses) Foreseeable risks Interlopers: SH rejection Interlopers: third-party bid Interlopers: regulatory approval Adverse change after signing the agreement

Contracting around the law Shopping for legal consequences
Board consent Mergers & asset sales require board approval Share acquisitions do not require board approval (Group) SH consent Mergers & asset sales require a majority in a SH vote Share acquisitions do not require a SH vote Individual SH consent Mergers & asset sales do not require individual SHs’ consent Share acquisitions require individual SHs’ consent SH appraisal rights Mergers & asset sales may trigger appraisal rights Share acquisitions do not trigger appraisal rights Will the law respect parties’ choice of deal structure?

Contracting around the law Magnolia’s at Bethany [Del. Super. 2011]
Magnolia’s sues Artisan for the damages caused by Meridian General rule: Y in asset sale is not liable for X’s obligations The Magnolia’s case describes exceptions to this rule: Assumption of liabilities (Y assumed X’s liabilities) De facto merger (deal was effectively a merger, not an asset sale) Successor liability (Y is a mere continuation of X under different name) Fraud – not alleged in Magnolia’s

Contracting around the law Magnolia’s at Bethany
Assumption of liabilities Express: Artisan did not expressly assume liability related to Magnolia’s (a completed project at the time of the acquisition) Implied: Did Y impliedly assume X’s liability by presenting the condo as their project on their Facebook page? Court: No. Posting aimed to solicit business (by showing projects their employees did); can’t be understood to intend to assume liabilities. Also, at time of posting Y likely didn’t know about the liability.

De facto merger General rule - doctrine of independent legal significance: a legal action taken under one provision of Delaware law is valid even if it would have violated another provision of Delaware law if it had been taken under the second provision (Hariton v. Arco Electronics, Inc. [Del. 1963]) Exception – de facto merger doctrine: transaction is considered to have legal consequences of a merger when three elements are satisfied: X transfers all of its assets to Y Y pays in stock, issued by Y directly to XS Y agrees to assume all the debts & liabilities of X Here, none of the elements are satisfied Y bought most, but not all of X’s assets Y paid in cash, not stock Y only assumed liability for uncompleted contracts & permits

Successor liability Occurs when the new entity is so dominated and controlled by the old company that separate existence must be disregarded (so new entity is liable for old entity’s obligations) “The test is not the continuation of the business operation; rather, it is the continuation of the corporate entity.” Evidence of continuation of the corporate entity: Common identity of the officers, directors, or SHs of the predecessor and successor corporations Existence of only one corporation at the completion of the transfer Here, no such evidence Artisan has different SHs (and likely officers & directors) than Meridian Both Artisan & Meridian existed after the transaction

Fraud Common law fraud requires five elements (Gaffin v. Teledyne [Del. 1992]): Misrepresentation: false representation made by the defendant Scienter: defendant's knowledge or belief that the representation was false, or was made with reckless indifference to the truth Intent: an intent to induce the plaintiff to act or to refrain from acting Reliance: plaintiff's action/inaction taken in justifiable reliance upon the representation Harm: damage to the plaintiff as a result of such reliance Equitable (or “constructive”) fraud replaces the scienter element with the existence of a fiduciary relationship (Zirn v. VLI Corp. [Del. 1996]; Klembczyk v. Di Nardo [NY App. 1999]) Here, no allegation of fraud (so case did not discuss fraud)

Contracting around the law Practice question
Y (Del. corporation worth $3B) wants to acquire X (subject to MBCA, worth $1B) Y & X want to structure the deal so that SHs won’t have an appraisal right Assume majority of SHs support deal, but a few will object Structure the acquisition (merger/asset sale/share acquisition) so that: One firm has both Y’s business & X’s business Y’s current SHs control 75% of that combined firm; X’s current SHs control the other 25% (Y is paying XS in stock, not in cash) The deal won’t give YS or XS appraisal rights Analyze whether your structure would withstand legal challenge Delaware MBCA Merger Appraisal Asset Sale No Appraisal Appraisal (seller only)

Acquisition basics M&A litigation Crafting acquisition agreements Document structure Contracting around the law Contracting around other contracts (change of control clauses) Dealing with interlopers Dealing with adverse change

Contracting around other contracts Anti-assignment clauses
X may have assets that lose value if X is acquired Regulatory permits that can’t be transferred Loans that default if there is a change of control (“CoC”) Why would a lender want this clause? Joint ventures that terminate upon CoC in one of the parties Why would parties to a joint venture want this clause? Simple CoC clause: anti-assignment clause Y wants to acquire X X has a joint venture with firm Z; agreement prohibits assignment of the contract How can Y acquire X without losing the joint venture with Z?

Contracting around other contracts Bypassing anti-assignment clauses
Tender offer + merger rather than asset sale Bypasses prohibitions on assigning contracts Because mergers bypass anti-assignment clauses, parties create CoC clauses that are triggered when there’s a change in the control of the party E.g., one person or group acquires over 50% of shares

Contracting around other contracts A more complex bypass
Schering-Plough, a pharmaceutical company, has a joint venture with Johnson & Johnson to market Remicade (an anti-inflammatory drug) J&J has right to market drug in US; S-P has right to market drug in rest of world Estimated value of S-P’s marketing rights: $10 B If there is a CoC at S-P, joint venture is terminated and J&J receives S-P’s marketing rights Any person becomes owner of over 50% of voting power/stock Any merger in which the party is not the surviving entity

On 3/10/2009, Merck signed agreement to acquire S-P for $41B (~$10B in cash, the rest in shares) How to structure the deal so joint venture isn’t terminated? To illustrate, assume that: S-P & Merck each have 1B shares outstanding S-P is worth $40B ($40/share) & Merck is worth $60B ($60/share) Deal calls for S-P’s SHs should receive $10B in cash, $30B in shares

S-P takes over Merck (reverse merger) S-P creates a subsidiary that merges with M M’s SHs get 1.5 shares of S-P for each M share they had Before… After… S-P’s SHs S-P’s SHs M’s SHs 1B S-P shares 1B S-P shares 1.5B S-P shares S-P M’s SHs S-P 1.5B S-P shares S-P Sub Merck S-P Sub (Merck) S-P now worth $100B, has 2.5B shares, so each share is worth $40

Success? Avoided triggering CoC clause? Any person owning >50% of S-P stock (>1.25B shares)? Merger in which S-P was not surviving party? Did S-P SHs receive the agreed upon consideration? 1B shares each worth $40 (=$40B); no cash Problem: S-P’s SHs need to receive cash – but they are the ones acquiring Merck Solution 1: S-P pays its SHs a $10B dividend, then reverse merges (this was not done – perhaps for tax reasons) Solution 2: S-P merges with a subsidiary & pays SHs cash, then reverse merges; here’s how it goes…

Implementing solution 2 Step 1: S-P creates two subsidiaries Sub 1 will be used to pay S-P SHs $10B (so S-P moves moves $10B cash to Sub 1) Sub 2 will be used to pay M SHs in a reverse merger (so S-P moves 2B S-P shares to Sub 2) S-P’s SHs 1B S-P shares S-P S-P Sub 1 ($10B in cash) S-P Sub 2 (2B S-P shares)

Step 2: S-P merges with Sub 1, paying its SHs $10 in cash + 1 share of “new” S-P for each share of “old” S-P they owned S-P’s SHs S-P’s SHs 1B old S-P shares 1B “new” S-P shares + $10B S-P Surviving Company (S-P) S-P Sub 1 S-P Sub 2 S-P Sub 2 S-P now worth $30B, has 1B shares, so each share is worth $30

Step 3: Now Merck merges with Sub 2 M’s SHs get 2 shares of S-P for each M share they had Success? Avoided triggering CoC clause? Any person owning >50% of S-P stock (>1.5B shares)? Merger in which S-P was not surviving party? S-P SHs received agreed upon consideration? 1B shares each worth $30 ($30B); $10B in cash S-P’s SHs S-P’s SHs M’s SHs 1B S-P shares + $10B 1B S-P shares + $10B 2B S-P shares S-P M’s SHs S-P 2B S-P shares S-P Sub 2 Merck S-P Sub 2 (Merck) S-P now worth $90B, has 3B shares, so each share is worth $30

Acquisition basics M&A litigation Crafting acquisition agreements Document structure Contracting around the law Contracting around other contracts Dealing with interlopers SH rejection Third-party bid Regulatory approval Dealing with adverse change

Interlopers: SH rejection The stakes
About 2-3% of M&A deals fail to close after they are signed (1.7% in 2007; 3.3% in 2009 [WSJ 8/6/13, p. B5]) Acquisition agreements usually address anticipated and common risks, attempting to mitigate them and to allocate the risk in an agreeable way between the parties We will discuss how agreements address the following risks SH rejection (SHs try to scrap the deal) Third-party bid (Y2 bids for X) Regulatory risk (regulator blocks the deal/party tries to avoid deal by thwarting regulatory approval) Risk of adverse change (events make X significantly less valuable)

Interlopers: SH rejection Avoiding individual SH approval
When Y wants to buy 100% of X, it needs a transaction form that does not require individual XS’s approval (to avoid SH hold-outs) I.e., merger or asset sale But first Y needs to get a controlling stake Needs XB approval, and often also (group) XS approval Common techniques Tender offer + LFM Tender offer + top-up + SFM Tender offer + DGCL §251(h)

Interlopers: SH rejection Tender offer + LFM
Yvonne makes a tender offer for X Conditioned on at least 50.1% of shares tendered SH Sam (24%) opposes the deal, but 51% of XS tender their shares Yvonne now appoints XB XB signs a merger agreement w/Yvonne’s wholly-owned company, S Merger requires SH vote; 60% vote in favor (51 out of the 60% are Yvonne’s shares) To avoid a claim that Yvonne influenced XB as a controller, Yvonne can negotiate the merger with XB (conditioned on tender offer’s success) before launching the tender offer How should Sam challenge this merger?

Interlopers: SH rejection Tender offer + LFM
Before tender offer After tender offer Sam Other SHs Yvonne Sam Other SHs 24% 76% 51% 24% 25% X X S-Co has a cash-out merger with Target Yvonne S 100% Yvonne forms S-Co Yvonne Sam Other SHs 51% 24% 25% 100% Cash S X After the merger Yvonne Sam Other SHs 100% Cash S (X)

Interlopers: SH rejection Tender offer + top-up + SFM
Freeze-out merger requires a SH vote which takes time Faster alternative: tender offer + top-up option from XB that brings Y up to 90% ownership of X, then a SFM Example: X has 100 shares (Y owns 0, wants to own 100) Announces a tender offer for all of X’s shares, conditioned on at least 85 shares tendered (hopefully threshold low enough to prevent holdout) At the same time, Y receives an option from XB that, conditioned on Y acquiring at least 85 shares, allows Y to purchase from X 50 newly-issued same price as tender offer Suppose 85 shares were tendered. Y exercises the top-up option to acquire 50 shares. Now Y owns 135 of 150 shares (90%). Y conducts SFM to freeze-out remaining 10% SHs XB often conditions top-up on Y’s promise to execute SFM immediately. Why?

Problems with top-up options: authorized share limit The lower the tender offer threshold required to exercise the top-up option, the more shares need to be issued in the top-up E.g., in our example, 50 shares were required for 85% threshold; if threshold was 50%, then 400 shares would be required To issue an option, enough authorized shares need to exist; in our example, X had to have at least 150 authorized shares Why is that a constraint? Can’t X just increase authorized shares?

Problems with top-up options: “appraisal dilution” Hypo: X has 100 shares; Y makes a tender offer for $10/share Sam, a SH, correctly believes that X is worth $2,000 ($20/share); he does not tender, and intends to seek appraisal 85 shares are tendered; Y executes top-up and buys 50 shares at $10/share (paying $500); then Y executes SFM X now worth $2,500 and has 150 shares; each share worth $16.67 Appraisal: even if court accepts that X was worth $2,000 pre-top-up, value drops from $20/share to $16.67/share because of the top-up Solution: Y can concede that appraisal value would exclude shares issued & consideration received in top-up

Interlopers: SH rejection Tender offer + DGCL §251(h)
Recognizing that top-ups make the SH vote meaningless when control was acquired in a tender offer, DGCL §251(h) allows to execute a tender offer + merger “combo” without a SH vote by X’s SHs, under the following conditions: X is a public firm (traded on a national exchange or has >2,000 SHs) Merger agreement expressly invokes section 251(h) and contemplates a merger with Y/S taking place immediately following a tender offer by Y/S At time X’s board approves the merger agreement, Y owns less than 15% of X Tender offer was for all shares entitled to vote on a merger Following tender offer, Y owns enough shares to win a SH vote on the merger SHs in merger receive same consideration as SHs who tendered in tender offer

Interlopers: third-party bid Why limit third-party bids?
Hypo: Target currently has a market value of $100K Kelly spots hidden value (believes X is worth $150K) Costs $10K to fully investigate X & prepare an acquisition offer Should Kelly spend $10K & make an offer to acquire X? What’s the highest price Kelly would offer for X’s shares? Kelly spends the $10K & offers to acquire X for $135K Craig, X’s CEO, tells Larry of Kelly’s offer Larry trusts Kelly’s business acumen & knows she spent some effort (at a cost of about $10K) to discover X’s value He doesn’t know exactly what she found, but if she spent $10K & then offered $135K for the company, then she found X is worth >$145K

Interlopers: third-party bid Why limit third-party bids?
Therefore, Larry offers to buy X for $145K That’s what Craig was hoping for when he told Larry of Kelly’s offer Should Kelly offer $146K? Make an ‘exploding offer’? (i.e., offer withdrawn if not accepted immediately) Is Craig harmed by Kelly’s rescinding of the offer? Doesn’t the offer still provide a good signal that would make Larry bid for X? Usually not feasible for M&A deals Knowing Craig’s incentives, would Kelly invest the $10K? To get Y to bid for X, X has to limit it’s ability to be opportunistic by agreeing to a “lock-up”

Interlopers: third-party bid How to limit third-party bids
Goals of a “lock-up” Reducing likelihood that Y2 acquires X No shop/go shop: limit X’s ability to negotiate with other potential acquirers Allow Y to take away “crown jewels” of X if Y2 acquires X Compensating Y if X walks away from the deal Termination fee Or, again, a “crown jewels” provision Lockup example (Van Gorkom): Pritzker demanded that TransUnion not solicit other bids & not furnish inside info to other bidders (TransUnion’s board rejected the latter demand) This is known as a “window shop” clause

Interlopers: third-party bid Shopping clauses
Deal terms re dealing with other bids: “No shop” clause: XB agrees not to solicit other bids or negotiate with other bidders At odds with XB’s fiduciary duty to get best deal for SHs (Revlon duties) “Window shop” clause: XB agrees not to solicit other bids, but may negotiate with unsolicited bidders Often comes with limitations on X providing info to Y2 Still runs risk of violating Revlon duties “Go shop” clause: allows XB to solicit other bids for a specified period If XB finds better deal, X pays termination fee & accepts better deal Provides XB with evidence this was best price available

Interlopers: third-party bid Termination fees
Types of termination fees Termination fee: fee paid by X if it walks away from deal Typical motivation: Y2 offered a better price Reverse termination fee (“RTF”): fee paid by Y if it walks Typical motivation: financing difficulties, change in X’s business/economic conditions that makes X less valuable Reverse termination fees do not address 3rd party risks; rather, they address risk of adverse change Termination fees are often a % of deal value (e.g., 3%)

Interlopers: third-party bid Other common techniques
Specific performance Parties must execute deal; paying damages/termination fee is insufficient Presents Revlon duty concerns; specific obligations are more often subject to specific performance, such as: “force the vote” clause (requires XB to bring deal to SH vote even if it decides to recommend another offer) If SHs vote against deal, X pays termination fee but has “out” If SHs vote to approve deal, X doesn’t have an “out” Why is this more acceptable than a “no shop” clause? Topping rights If X gets a superior offer, it must give Y several days advanced notice before it terminates; in that time, Y may get back with an offer that would make Y2’s offer not superior

Interlopers: Regulatory approval Main concerns
Many transactions require regulatory approval E.g., antitrust, banking, energy, telecom, foreign investments Merger agreement needs to address 2 related issues Who bears risk that deal will not receive approval? Bargaining power Efficient to place risk on party that can thwart approval Ensuring parties’ best efforts to obtain regulatory approval Agree on max concessions each party will make to get approval? Drafting obligations in way that makes concession allocation enforceable (ADS v. Blackstone)

Interlopers: Regulatory approval Alliance Data Systems v
Interlopers: Regulatory approval Alliance Data Systems v. Blackstone [Del. Ch. 2009] Case is an exercise in contractual interpretation Offers glimpse into what a merger agreement contains Illustrates how private equity deals are structured

Interlopers: Regulatory approval Alliance Data Systems v. Blackstone
Deal structure Blackstone Group (LP) Investors A word about how private equity is structured BCP V (LP) Other investments Aladdin Solutions ADS’s SHs Alliance Data Systems Aladdin Merger Sub World Financial

Deal structure Blackstone Group (LP) Banks BCP V (LP) $81.75/share; total: $7.8B Aladdin Solutions ADS’s SHs BCP V creates AS & AMS Alliance Data Systems Aladdin Merger Sub BCP V & banks give contractual commitments: $1.8B in equity LBO $6B in debt (77% debt)

The Merger Agreement Blackstone Group (LP) (b) BCP V guarantees AS’s payment of $170M reverse termination fee BCP V (LP) Aladdin Solutions (a) Parties to the merger agreement (in pink) Alliance Data Systems Aladdin Merger Sub (c) Credit-card company - needs OCC approval World Financial

Blackstone rejects OCC’s demands from it OCC refuses to approve deal Agreement’s deadline passes; Aladdin terminates it ADS claims Aladdin breached Agreement by failing to make Blackstone accommodate OCC demands Sues Aladdin & BCP V to collect the reverse termination fee Relevant provisions in the merger agreement §6.5.1: covenant by Aladdin to use its reasonable best efforts to secure necessary regulatory approvals §6.5.6: covenant by Aladdin to keep Blackstone from preventing or impeding the completion of the merger §5.2: representation by Aladdin that it had the power to fulfill its obligations under the merger agreement Implied covenant of good faith & fair dealing

§6.5.1: reasonable best efforts to secure regulatory approvals Court: clause applied only to Aladdin, not Blackstone Best practices include a covenant by acquirer that its parent will also work toward completion of the transaction Elsewhere in the agreement, different language makes Aladdin liable for Blackstone’s conduct Antitrust approval in §6.5.1: Aladdin covenants that it “shall, and shall cause each other member of the Parent Group… to take any action which it is capable of taking [to get antitrust approval].” Known as “hell or high water” obligation §6.5.6: covenant by Aladdin to keep Blackstone from preventing or impeding the completion of the merger

§6.5.6: Covenant to keep Blackstone from preventing or impeding the completion of the merger Court: this is a negative covenant holding Aladdin liable for affirmative action by Blackstone that thwarts merger’s closing Affirmative covenants require a bound party to take action; negative covenants forbid action What is the relevant action? ADS: Engaging the OCC & rejecting its proposals Court: No; Blackstone was not obligated to engage with the OCC

§5.2: representation by Aladdin that it had the power to fulfill its obligations under the merger agreement ADS: This represents that Aladdin controls Blackstone Court: No. This represents that Aladdin can make Blackstone behave according to the narrow obligations it covenanted to (antitrust approval & not acting to thwart deal) Implied covenant of good faith & fair dealing Requires a party to refrain from unreasonable conduct which has the effect of preventing other party from receiving fruits of the bargain Court: applies when contract lacks specific language governing an issue & obligation advances purposes reflected in contract’s express language; here, language is clear

Adverse change Common protections
Party’s condition may change between signing the deal & closing it (transferring the shares/assets) Protecting X: risk that X will increase in value Earn-out: additional payment based on X’s future performance relative to baseline set in merger agreement When parties can’t agree on price, earn-outs that apply to post-closing performance may be used (in such cases, Y may have post-closing covenants to prevent manipulation of X’s profits) Protecting Y: risk that X will decrease in value Earn-out: low base price, the rest tied to future performance Material Adverse Change (MAC)/Material Adverse Event (MAE) clause: Y has an “out” from deal if X suffered a material adverse change

Adverse change Typical MAC clause structure
General rule: Y can walk away from deal if X suffered MAC Absence of a MAC is a condition precedent to Y’s obligation to close the deal (Hexion) X represents & warrants that no material adverse effect occurs (IBP) Exceptions (carve-outs): events that aren’t MACs; e.g.: Changes in general conditions of the specific industry Changes in general political, economic or financial conditions Changes in law/interpretation of law by courts/government entities Changes in GAAP or regulatory accounting requirements Actions/omissions taken with the prior written consent of other party Practical note: litigation on MACs is rare; typically, invoking MAC is a step in renegotiating the deal But law influences the negotiations (since it determines what happens if parties can’t settle)

Adverse change Hexion v. Huntsman [Del.Ch. 2008]
Hexion (Y) alleges three MACs occurred to Huntsman (X) Huntsman had disappointing earnings from time of signing the merger agreement (7/2007) to time of trial Increase in Huntsman’s net debt since signing, despite expectations that debt would be reduced Underperformance in Huntsman’s Textile Effects & Pigments lines of business Economic background: Huntsman suffered from - High oil prices increased cost of petroleum derivatives (Huntsman’s raw materials) Weak dollar increased cost of inputs (Huntsman sells products in dollars, but pays for inputs in foreign currency)

Adverse change Hexion v. Huntsman
Huntsman had disappointing earnings Court examines business performance using EBITDA (earnings before interest, taxes, depreciation & amortization) First-half EBITDA down 19.9% year-over-year Huntsman optimistic about 2009; Hexion pessimistic Current analyst estimates project 2009 EBITDA that is essentially flat from 2007 to 2009 Court: Not a MAC Drop in earnings seems like a temporary dip & is not large enough Significant drop compared to Huntsman’s projections, but §5.11(b) disclaims Huntsman projections

Increase in Huntsman’s net debt since signing, despite expectations that debt would be reduced At time of signing, Huntsman had a net debt of $4.1B Huntsman time of signing that by end of 2008 its debt would be ~$3B (this includes ~$800M from divestiture of assets) Ended 2008 with debt increasing by ~$250M (~6% increase) So debt was $4.35B instead of projected $3B (~ 45% increase) Court: Not a MAC (2 of 4 Hexion models at signing assumed debt of $4.1B) Underperformance in Huntsman’s Textile Effects & Pigments lines of business Court: MAC clause addressed impact to entire business; impact on specific divisions doesn’t matter Also, bad performance in these divisions seems to be short-term

General points court makes in analyzing MACs Burden of proof is by default on party claiming MAC, regardless of the form the MAC has (representation, condition precedent, etc.) Must show that MAC occurred before exceptions are examined I.e., showing a disproportionate impact of event on T only matters if there’s also a showing that event was a MAC Very high threshold for what constitutes a MAC

Adverse change Interactions between clauses
Interaction: MAC & RTF Many deals have both a MAC & a RTF MAC – Y can terminate contract if MAC occurs RTF – Y’s liability for breaching contract capped at fee All else equal, is Y more likely to invoke a MAC when deal has a RTF, or when deal doesn’t cap damages for Y’s breach of contract? Interaction: MAC & regulatory risk When addressing regulatory risk, parties may bargain for right to refuse to accommodate regulators One way of doing so is via a MAC clause (instead of agreeing on maximum concessions party must offer) Example (Delta/Northwest merger): each party may terminate deal if a regulator requires asset divestiture or other actions that would have a MAC on one of the parties or combined entity

Prof. Amitai Aviram University of Illinois College of Law

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Prof. Amitai Aviram University of Illinois College of Law

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