The result was a win for the opponents of Omnicare. Omnicare can now be said to apply in the narrow circumstance where controlling shareholders can’t act by written consent immediately or the extreme circumstance of Bear Stearns, where a board of a company attempts to pass control to an unaffiliated third party without a shareholder vote. Given that in most situations, this is not the case, Omnicare today has limited applicability, and the Delaware Supreme Court may not even get the chance to overrule it because of the unique facts required to implicate it.
The result of these cases is to classify strategic transactions into two modes, cash or stock. Cash deals are reviewed under higher Revlon standards. In effect, the vicissitudes of Revlon and the lower standard of Unocal matter only if a company agrees to sell. A company has wide latitude to just say no. Once it says yes, it can agree to lockups that potentially preclude other bidders. Again, the only limitation is what the company must do if a higher bidder comes along. If acting under Revlon, then the company must keep itself up for sale, arguably up to a shareholder vote on the transaction. If the deal is for stock consideration, the company can simply agree to these protections and fight off a higher bidder. The consequence is that buyers and targets have every incentive to structure a deal as a stock transaction in order to avoid this differential.
Delaware thus allows wide latitude for targets to negotiate these lockups in deals outside Revlon. Buyers also have every incentive to push for the most restrictive lockups possible in the form of break fees. This has resulted in an average break fee of 3.5 percent and 3.53 percent in 2008 and 2007, respectively. But 22 percent and 23.2 percent of deals in 2008 and 2007, respectively, had a break fee higher than 4 percent.51 Compare this with an average break fee of 2.8 percent before Brazen.52 The effect of these lockups is enhanced because shareholders almost never vote down acquisition proposals put forth for their approval. From 2003 through 2007, only nine takeovers were rejected by shareholders.53 To some extent, this reflects the fact that these votes almost never occur when defeat is certain. Still, the result is the apparent rise in more restrictive lockups cited by Professors Coates and Subramanian. Whether this conduct actually forecloses alternative deals, as Professors Coates and Subramanian claim, or will otherwise be countered and adequately curbed in the future by shareholder activism remains an open question.
In the meantime, Delaware would do well to maintain a hard focus on these lockups, largely limiting break fees to a 3 percent range and putting forth a coherent reason for a liquidated damages provision at this level or above as truly incentivizing bidding. In addition, break fees payable upon a shareholder no-vote should be strictly scrutinized as limiting shareholder choice. Bidders should be compensated for bidding, but when lockups forestall a bidding competition and overcompensate, this is detrimental to shareholders. This is particularly true outside the Revlon process where a board can just say no to the hostile bid, erecting a double wall to any acquisition. A strict court policing of lockups is thus likely to be beneficial.
Revlon and the Market Check
If a board decides to sell in a cash deal, then Revlon duties apply to regulate the board’s conduct vis-à-vis any competing bids. In repeated cases, the Delaware courts have acted under Revlon to erect a level playing field. In the case of competing bids, Revlon duties come into play to keep the playing field further level. First, Revlon duties serve to regulate the type of deal-protection devices a company can agree to with a buyer. Second, in this context, Revlon operates to regulate what a board, deciding to put itself up for sale, must do to satisfy Revlon’s price dictates. 54 This latter requirement has unfolded around the question of what type of market check a Delaware company must undertake, if any, once it decides to sell, and if the company does not perform a market check, what deal protection devices it can adopt. A market check is a procedure whereby a target’s investment bankers canvass the market for potential bidders before a target agrees to an acquisition with a preselected buyer.
The need for a market check under Delaware law has always been debated, but in cases from the 1980s, the Delaware courts have refused to pigeonhole companies on the procedures it must use to shop itself or otherwise require an auction of the company when it is put up for sale.
Instead, in a string of cases through In re Pennaco Energy, Inc. S’holders Litig.55 and In re MONY Group S’holder Litig.,56 the Delaware courts held as reasonable deal-protection devices combining no-solicit provisions with approximately 3 to 4 percent termination fees by equity value, and in both cases these provisions were agreed to prior to the target’s solicitation of any competing offers. In other words, in these cases the courts validated these lockups despite the lack of a market check.
In this regard, the Delaware courts allow termination fees to be set within a range of value that is typically within 2 to 4 percent of the transaction value, though the question of whether transaction value is based on the equity or enterprise value of the company remains open.This permissibility is effectively equivalent, though perhaps slightly stricter, than that allowed for termination fees in strategic transactions not subject to Revlon. This principle was reconfirmed in 2005 in In re Toys “R” Us, Inc. S’holder Litig.57 In Toys-R-Us,Vice Chancellor Strine upheld a termination fee of 3.75 percent of the target’s equity value and 3.25 percent of the target’s enterprise value agreed to prior to a market check.58
A board acting under Revlon duties can thus preagree to a deal and also agree to relatively strong transaction defenses under Delaware law without preannouncement contact of other bidders. The board would need to negotiate a fiduciary out, subject to these breakup fees and other transaction defenses, if a higher, competing bid emerges and is superior. But this provides a board substantial latitude to negotiate protection for their current deal.
Starting in 2003, a modified form of market check began to appear, mostly in private equity transactions. This was the go-shop. The go-shop in its standard form allowed a 30-60 day period after announcement of the transaction for the company to speak to other bidders. In other words, to go-shop.Thereafter, the normal provisions that prohibit the target from soliciting other bids would apply. In addition, during this time period, the breakup fee would often be reduced from approximately 3 percent of transaction value to 1 percent.
The go-shop saw widespread utilization in private equity deals. Despite practitioner sense that these provisions were cosmetic, designed to provide reputational cover to done deals, one study has found that these provisions add value in the context of buyouts where management was not involved.59 Moreover, in the Netsmart case, the Delaware Chancery Court held that a board breached its Revlon duties by, in the context of a go-shop, limiting its solicitation to private equity buyers and excluding strategic buyers. In that case, the court endorsed a go-shop as one part, though not a necessary part, of a market check.60 Netsmart followed the Delaware courts’ penchant to strike down no-talks. No-talks are provisions that disallow a target from speaking to a postannouncement third-party bidder even if the bid is superior.
This leaves boards in Revlon-land with limits on termination fees and no-talks similar to strategic transactions outside Revlon. But ultimately, the difference between Revlon review for cash deals and Unocal review for stock deals appears limited. For boards acting under Revlon review, it principally appears to be an open playing field requirement and perhaps tighter requirements upon break fees and lockups. The board cannot place any arbitrary limitations and must run an open sale process that includes consideration of all reasonable bids. Delaware seems moving toward endorsing go-shops more explicitly, but given the limited evidence of their efficacy, it is unlikely to be a strong tendency. Instead, go-shops are likely to remain a modestly used device limited primarily to the private equity sphere.
The result is that strategic buyers and targets will still have modest incentives to structure their deals around Revlon. This is a historical advantage that strategic buyers enjoy over private equity buyers, who can only
offer cash. This advantage went by the wayside in the sixth wave due to the credit bubble. The end of easy credit will restore this advantage and further put strategic buyers ahead of the bidding curve with respect to takeovers. Again, though, the extent of this advantage and whether it is curbed by shareholder activism and a rise in no-votes on acquisition proposals remains a story yet to unfold. But excessive lockups may be one area where shareholder activism may not be sufficient to curb management entrenchment, given the historical penchant of, and forces upon, shareholders to approve acquisition transactions.
The Future of Strategic Transactions
The deal machine and personality-driven dealmaking has been hit terribly by the financial crisis and the rapid collapse of many companies and emperors, such as Sumner Redstone’s Viacom and CBS and Sandy Weill’s Citigroup. Both of these empires were created through dealmaking by driven, ego-driven CEOs, and both stumbled hard in the credit crisis. The accusations against John Thain and Ken Lewis in the sale of Merrill Lynch to Bank of America have further illustrated the perils of personifying strategic deals.
In the Merrill sale, John Thain, former CEO of Merrill, was accused of concealing from Bank of America a $15.3 billion loss and paying an inordinate sum in bonuses to Merrill employees prior to the closing. Meanwhile, Ken Lewis was accused of forcing through the transaction and concealing Merrill’s troubles from his own shareholders in order to obtain their necessary approval of the transaction. In the haze of spin, it was unclear whether the accusations were true, but they left a terrible tarnish on both men’s reputations.Thain’s image particularly suffered in light of the disclosure that he had spent $1.22 million redecorating his office suite at Merrill, including purchasing a commode for $35,000.61 A commode, by the way, is a fancy name for a toilet. Thain subsequently repaid this amount but the public tarnish, whether justified or not, remained.
The personality-driven model remains intact, but it is more limited than in prior years.The focus on disciplined takeovers in the sixth wave will continue to affect the course of strategic transactions. The trend is toward this discipline, particularly in light of the greater shareholder activism spurred by hedge funds and other activist investors. However, the continuing latitude buyers enjoy to acquire companies will work to keep personality an important force in strategic takeovers.
The big deal, though, is unlikely to be a prominent feature of the takeover landscape for the foreseeable future. Rather, strategic transactions will tend to be bolt-on deals, incremental acquisition upon existing businesses. Private equity will eventually return to dealmaking. But private equity will return in a submissive role, once again unable to outbid strategic bidders, and as a smaller part of the market.The end result is that strategic transactions are likely to dominate private equity in the coming years of diminished dealmaking.
In this market, stock will again probably become the preferred acquisition currency. The principal reason is that stock is a readily available acquisition currency, whereas cash financing is often unobtainable in this credit market. Moreover, in an economic downturn, buyers prefer to maintain their cash reserves. In a depressed market, paying with stock also allows the buyer to keep target shareholders in the game and provide them with a right to participate in the future upside of any acquisition. These trends have already begun to take effect. In both 2007 and 2008, more than 66 percent of all announced takeovers consisted of cash. However, in 2008 takeovers with only stock consideration rose approximately from 12 percent in 2007 to 17 percent in 2008.62
The principal problem with paying stock consideration in any financial crisis is that stock fluctuates in price. If the market is moving 1 to 5 percent in any given day, then pricing is impossible for any acquisition. In such a situation, companies try to bridge the gap.They do so by negotiating collar mechanisms that limit the maximum and minimum amount of stock that can be issued. In 2008, 34 percent of transactions offered stock consideration either alone or with cash, but only 9.2 percent of those had a collar.63 This number should rise as collars become more frequently used in response to a continuing volatile market.
Still, valuing stock in this environment is difficult, and so other exotic instruments such as contingent value rights (CVRs) have begun to emerge to bridge the valuation gap. CVRs pay upon the occurrence of particular events. In 2008, they saw particular use in pharmaceutical deals. Buyers would pay a set price together with a CVR that paid further consideration only if a certain drug or other product met certain financial goals or was otherwise approved by the Food and Drug Administration. By offering these alternative securities, deals in this difficult environment were able to bridge the consideration gap. Still, CVRs had only a very confined use.64 Buyers otherwise struggled to find a stable acquisition currency in this market as collars and alternative consideration only partially filled the gap.
The struggle over pricing and consideration reflects wider change in the world of strategic transactions. The financial crisis is spurring a rethink of the structure of strategic deals, leaving a number of unanswered questions, answers that are likely to come only in future years:
• The Structure of Strategic Deals. Buyers, particularly in more significantly sized transactions, are likely to increasingly demand more optionality in acquisitions where financing is necessary. Targets will continue to resist, but their level of resistance will depend upon the market and their bargaining power, power that is substantially diminished in a distressed market. It is likely that in this world, optionality with respect to financing will continue to creep into strategic agreements. But still the bigger question is an open one. What will happen when market normalcy returns? Will strategic buyers revert to more certain structures to show their greater closing willingness than private equity firms? Alternatively, will buyers fearful of the credit problems of the prior years continue to insist on optionality along the Pfizer model or variations of it?
• The Scope of a Market Check. The scope and parameters of a market check are still also very much in flux. Delaware has confirmed that postsigning market checks are acceptable. But go-shops have become the norm, at least in private equity deals and deals with management involvement. While this standard is likely to remain, the question remains how widespread outside this context go-shops become and whether their use serves as a simple cosmetic to cement a certain deal or otherwise facilitates higher bidding by buyers.
• Distressed Deals. The current extreme dealmaking for distressed targets has reflected the changed bargaining leverage between targets and buyers. The extreme provisions have the potential to seep into normal strategic transactions, further enhancing optionality in the strategic context. In pushing the envelope on structures to guarantee deal certainty, buyers are also setting up the Delaware courts to again address the permissible scope of lockups in distressed acquisitions and beyond.
• Limits on Buyers. Notable in Delaware law is the lack of limitations on buyers making deals, good or bad. Although the force of shareholder pressure, good corporate governance, and conventional wisdom about takeovers is likely to continue to provide a heightened monitoring process, the deal machine and issues of ego will continue to counteract these influences. Delaware, though, is unlikely to act for practical if not theoretical reasons. How would one even begin to monitor these decisions? The end result is that buyers will continue to have unrestricted discretion for takeovers, limited only by these economic and social forces.
• Shareholder Activism. Shareholder activism and good corporate governance practices as encouraged by the proxy services have proven effective in eliminating company defenses and encouraging the adoption of majority voting.The continued rise of these forces, led by hedge fund activist investors, may continue to put pressures on dealmaking, affecting the course of deals and the scope of lockups. In particular, the continued rise of these forces may substitute for more searching, needed review of lockups by Delaware courts.
The answers to these questions will affect the course of strategic tra
nsactions and dealmaking generally. But the strategic transaction will probably remain not only dominant but also the focus of change in coming years. This is particularly true in the case of distressed strategic transactions. These transactions are likely to spur innovation in structures and terms, innovation that is likely to seep into more ordinary strategic deals.The return of strategic dealmaking to prominence, though, is subject to a significant caveat. The activities of the biggest dealmaker in history, the federal government, will continue to overshadow private dealmaking, even as strategic transactions continue to return to the forefront.
Chapter 10
AIG, Citigroup, Fannie Mae, Freddie Mac, Lehman, and Government by Deal
The government moved full force to save the financial system in September 2008. Dealmaking did not disappear during this time. Instead, dealmaking took on new forms, as distressed acquisitions became common and the biggest dealmaker of all-time entered the market—the federal government led by Treasury Secretary Henry “Hank” Paulson Jr. and his team of former investment bankers. This chapter is about this activity, the incredible story of the government’s frenzied attempt to save the financial system. In four short months, the government would allow Lehman Brothers, IndyMac Federal Bank, FSB, and Washington Mutual to fail; arrange bailouts or shadow bailouts for Bank of America, Citigroup, and Morgan Stanley; nationalize AIG, the Federal National Mortgage Association, more commonly known as Fannie Mae, and the Federal Home Loan Mortgage Corporation, also known by the nickname Freddie Mac; force the sale of Wachovia; arrange for the passage of the $700 billion Emergency Economic Stabilization Act of 2008, otherwise known as the TARP bill; and implement a controversial program to save General Motors Corporation, Chrysler L.L.C., and each of their financing units. A list of the significant financial institution government investments during this time is set forth on Table 10.1.
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 28
