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Piotr Korzynski is an associate at Baker & McKenzie LLP. This post is based on a publication by Mr. Korzynski and is part of the Delaware law series; links to other posts in the series are available here. This post represents the views of the author and not necessarily the views of Baker McKenzie LLP.
In the four and a half years since the Delaware legislature adopted Section 251(h) of the Delaware General Corporation Law (DGCL) and offered streamlined mechanics for closing two-step mergers, Delaware practitioners have made increasing use of the provision. The provision, subject to certain conditions, permits an acquiror’s near-simultaneous closing of an exchange or tender offer for a controlling stake in a target in the first transaction step and a merger for the remaining outstanding stake in the target immediately after in a final, second step. In its initial year, Section 251(h) was utilized in over 20% of deals involving Delaware public company targets and 33 of 41 Delaware two-step mergers. [1] In 2014, following the success of that first year, the legislature liberalized the use of Section 251(h) by, among other things, striking the condition that the provision was inapplicable to transactions involving “interested stockholders” (i.e., owners of 15% or more of a target company’s outstanding voting stock at the time of target board approval of the merger agreement). Such condition had restricted Section 251(h) transactions to true third-party transactions and likely depressed its use in the first year. By its third full year, nearly 25% of deals involving Delaware public company targets and 49 of 52 Delaware two-step mergers utilized Section 251(h).
As the provision has quickly become a linchpin of Delaware M&A, this post considers a buyer’s ability under Delaware law to gain closing certainty in two-step mergers via support agreements with controlling target company stockholders. As used here, “support agreements” are agreements between a potential buyer and controlling target company stockholders in which, at deal signing, such stockholders agree to exchange or tender some or all of their shares as soon as or shortly after the first-step tender or exchange offer commences, thereby giving a buyer assurance of substantial and even decisive stockholder support for the merger. At bottom, just as in the pre-Section 251(h) era, a buyer must carefully structure such agreements to avoid a deal becoming an impermissible fait accompli under the Delaware Supreme Court’s long-standing decision in Omnicare v. NCS Healthcare, with special attention to the mechanics of consummating an exchange or tender offer. [2]
In 2003, in Omnicare, the Delaware Supreme Court enjoined a one-step merger between Genesis Health Ventures and its target, NCS Healthcare. The court held that the NCS directors were precluded from exercising a continuing obligation to discharge their fiduciary duties after announcement of the merger agreement because (1) the board approved voting agreements with NCS stockholders holding in excess of 50% of the outstanding voting power, ensuring approval of the merger at the NCS stockholder meeting; (2) the merger agreement included a “force-the-vote” provision requiring that NCS hold a stockholder vote notwithstanding any change in the NCS board’s recommendation of the merger (including in respect of any competing offers); and (3) the merger agreement did not include a “fiduciary out,” i.e., a right of NCS to terminate the merger agreement to accept a superior, competing offer. The NCS directors’ hands, in other words, were tied—at signing, the deal was a fait accompli in respect of any superior offers, subject only to a procedural stockholder vote and customary closing conditions. Such a scenario, the Delaware Supreme Court ruled, was illegal per se, regardless of any robust auction process or even the behest of controlling stockholders.
Omnicare’s progeny support the case’s applicability to a two-step merger. In 2011, for example, the Delaware Chancery Court’s decision in In re OPENLANE, Inc. Shareholders Litigation upheld a merger approved by a majority of target stockholders by written consent the day after the merger agreement was signed and which did not include a fiduciary out. The court upheld the merger as stockholders could freely choose to sign the written consent; the result was not predetermined; and the target was not precluded from entertaining other offers because if the consents were not secured within 24 hours, the target could terminate the merger agreement. OPENLANE made clear that Omnicare’s application was not limited to mergers approved at stockholder meetings, and there is little doubt that two-step mergers would be subject to an Omnicare analysis. Indeed, under Delaware law, the ultimate effect of an exchange or tender of shares in the first step of a two-step merger under Section 251(h) is the same as a vote at a stockholder meeting or execution of a written consent: each tender or exchange is an approval of the underlying transaction by the applicable stockholder and ultimately contributes to effectuating the transaction, subject to a transaction’s other terms and conditions.
Though Omnicare has been much criticized by some practitioners and its applicability narrowed by subsequent cases, the case remains good law in Delaware with respect to its particular “lock-up” scenario, and in any Delaware target two-step merger, proposed support agreements will have to be prepared in an overall deal structure that distinguishes itself from some or all three key defects identified in Omnicare.
At first blush, a two-step buyer might distinguish its deal from Omnicare by altogether avoiding support agreements. Understandably, this has not been the standard practice in Delaware two-step mergers involving controlling stockholders, given that in such contexts a buyer would likely want to both raise deal certainty and signal to the market support for the transaction from the party or parties holding controlling shares. Indeed, in a review of post-Omnicare two-step mergers both pre- and post-Section 251(h) involving Delaware public company targets with 50% or greater controlling stockholders, [3] nearly all (22 of 24 deals) included support agreements from the controlling stockholders. Thus, the prevailing question for buyers in such deals apparently has been not whether to pursue support agreements but what such agreements should look like. The prevailing response has been to include a fiduciary out in the merger agreement: in a plurality of the controller deals with support agreements (eight of 22), controlling stockholders pledged the tender or exchange of all their shares unless the merger agreement was terminated, which merger agreement included a target termination right to take a superior offer, and such termination was the only avenue for reducing or terminating the tender obligation in connection with a board’s exercise of fiduciary duties in respect of superior, competing offers.
Though a fiduciary out alone would seemingly be enough to avoid Omnicare’s prohibition, in an additional 13 deals, a fiduciary out was one of two (or in a couple of cases, three) mechanisms reducing the tender obligations under the applicable support agreement. In nine of these 13 deals, the primary recurring additional mechanism was some form of a “ratchet down” of tender obligations (e.g., upon a certain event other than merger agreement termination, the tender obligations were reduced to 34.99%, paused entirely for the period of board recommendation change or terminated entirely at board recommendation change). In the remaining four deals (and two of the nine ratchet deals), the additional mechanism was an express cap on the shares subject to the support agreement, as the parties did not subject all of their shares to the support agreement. The caps were generally between 31.99% and 39.99%, with one deal at 14.9%. The latter cap, however, was addressed not to Omnicare concerns but to Section 251(h)’s prior restriction against transactions involving interested stockholders, [4] which restriction, as noted above, has since been lifted.
Finally, one deal among the 22 controller deals with support agreements conditioned the controlling parties’ tender obligations on the acquiror’s deal financing being secured as the only apparent Omnicare mechanism for avoiding the deal becoming a fait accompli.
Interestingly, only one of the 21 controller deals reviewed above included what might be called a “force-the-offer” arrangement akin to a force-the-vote provision in a one-step merger. Among one-step mergers involving controlling stockholders post-Omnicare, an accepted deal structuring practice has been to retain a force-the-vote provision as in Omnicare itself but to ratchet down the level of guaranteed support from over 50% to around 33% following a board recommendation change. The arrangement avoids a fait accompli in the ultimate vote but still gives a buyer a clear up-or-down vote on its proposed deal notwithstanding any interlopers. The only two-step merger among the controller deals that appears to have applied this logic onto an exchange or tender offer was Liberty Interactive Corporation’s 2015 cash-and-stock acquisition of zulily, inc. for about $2.3 billion. There, a support agreement was entered into by zulily stockholders representing 87.5% of the outstanding voting power and included a ratchet down of support to 34.99% in the event of, among other things, the board’s subsequent recommendation against the deal in connection with a superior offer. The merger agreement also included a fiduciary out for zulily, but with a twist: zulily could terminate the merger agreement to take a superior offer only after 45 days had passed from its board’s recommendation change. In effect, that 45 day waiting period created a window in which Liberty could nonetheless force the offer on zulily stockholders notwithstanding a competing superior offer and hold a referendum on its deal.
While the ultimate legal effect, noted above, of a tender or exchange of shares is the same as a vote of such shares at a stockholder meeting, the dynamics of an exchange or tender offer are fundamentally different from a discrete vote at a meeting or sign-and-consent. From the buyer’s perspective, to truly parallel a force-the-vote requirement, a force-the-offer mechanic would have to frame a clear referendum on the offer itself. Under SEC rules, offers must initially be held open for at least 20 business days, and following material amendments to an offer, an additional 5 business days. From these SEC rules, two-step merger parties typically provide for the initial required 20 business day offer period and then a default right of the buyer to renew the offer period thereafter for some shorter periods until the merger agreement is terminated. In this process, any major conditions to the offer will have a significant effect on the level of interim stockholder tenders or exchanges; for example, if an offer period would otherwise end with an antitrust waiting period still in effect under the Hart-Scott-Rodino Act, few stockholders, all things being equal, will have tendered or exchanged shares, most waiting for announcement of that condition having been satisfied. One would expect a buyer, especially if faced with an uncertain antitrust clearance period or other uncertain condition, to push for a force-the-offer period to be the time between a board recommendation change for a superior offer and some range of days following the satisfaction of all conditions to the offer other than (1) the tender or exchange of a minimum number of shares needed for approval of the merger and (2) those other conditions that could only be satisfied as of closing.
In this respect, the zulily mechanic is not as buyer-friendly as a more conditional mechanic, since the force-the-offer period was simply 45 days from the recommendation change, without regard to what conditions to the offer were or were not otherwise satisfied. The zulily mechanic might, however, be more Omnicare-friendly, since the force-the-offer period runs for a less open-ended period than the conditional mechanic noted above and so is likely less preclusive of competing bids. The extent to which, however, parties would be concerned with such preclusive effect would be dictated by the deal context as a matter of law and negotiating leverage. If a robust auction process led to the transaction, for example, then parties could more defensibly exclude a fiduciary out from a merger agreement that might otherwise be dictated by Delaware law and could instead focus on distinguishing their structure from Omnicare by a force-the-offer mechanic alone and one with a more open-ended force-the-offer period than in Liberty-zulily.
In the Section 251(h) era, the three pillars to Omnicare’s holding—voting agreements guaranteeing a majority vote in favor of a deal, a force-the-vote provision, and no fiduciary out—remain essential for understanding the limits of just how much support buyers of Delaware corporate targets can lock up via support agreements. Considering these three factors, practitioners seem to have relied on fiduciary outs, together with a ratchet down of tender obligations, to avoid impermissible fait accomplis in two-step mergers with controlling stockholders and support agreements. Among the deals reviewed here, only one deal, the Liberty-zulily merger, included what one might consider a force-the-offer provision, or a provision conceptually equivalent to the force-the-vote provision in Omnicare, while also providing a ratchet down of tender obligations. Buyers subsequently considering a force-the-offer provision might want to take account of how such a provision might be more aggressively drafted to frame a clear referendum for stockholders on a buyer’s proposed deal (and perhaps to offer some additional deterrence to interlopers in light of a longer potential pursuit period). Ultimately, of course, the mix of particular deal protections a buyer or seller can secure consists of not only what the law allows (including in respect of market checks on deal consideration that might separately require fiduciary outs in Delaware) but also the relative negotiating leverage among the parties.
1 Based on FactSet/MergerMetrics.(go back)
2 The two-step mergers under discussion here do not include going-private transactions involving controlling stockholders wherein such stockholders themselves initiate a two-step merger. Such transactions are inherently fait accomplis in respect of stockholder approval and subject to procedural safeguards arising from a separate landmark Delaware Supreme Court decision, Kahn v. Lynch.(go back)
3 Generally as reported by DealPoint as of March 12, 2018 from among deals with at least one stockholder owning at least 30% of outstanding shares.(go back)
4 In the year that Section 251(h) included an interested stockholder restriction, commentators observed that DGCL Section 203, from which the interested stockholder definition was drawn in Section 251(h), broadly defined “ownership” of 15% of a company’s outstanding shares such that a support agreement might imbue a buyer with ownership of a counterparty shareholder’s shares, thereby violating the then-applicable 251(h) restriction.(go back)
