Article by Mark H Burnett, Kathy A Fields, Roger A Lane, William L Prickett
On April 4, 2003, the Delaware Supreme Court issued a rare 3-2 split decision that invalidates a combination of frequently-used measures to lock up merger transactions. In Omnicare, Inc. v. NCS Healthcare, Inc., the Court nullified the deal protection terms of a negotiated merger transaction that included: (1) an irrevocable agreement among the holders of 65% of the target’s outstanding stock to vote in favor of the deal; (2) an agreement to put the merger to the target stockholders for a vote, even if the board of directors withdraws its recommendation of the deal; and (3) the lack of an effective fiduciary out. The Court determined that this combination of defensive measures guaranteed that the merger would be approved and eliminated any ability of stockholders to reject the transaction. Accordingly, the Court ruled that the measures were per se invalid and unenforceable.
While the holding in Omnicare may be limited to its unique facts, directors considering business combinations will need to exercise increased caution in the areas of fiduciary outs, stockholder voting agreements, and other deal protective devices. After Omnicare, it appears that any combination of protective measures that irrevocably locks up a merger transaction is at risk of being held invalid, and a target company’s board is well-advised to negotiate an effective fiduciary out in the transaction.
Factual Background
In early 2000, NCS Healthcare, Inc. ("NCS"), facing imminent insolvency, hired an investment banking firm to assist it in identifying potential acquirors or equity investors. The investment bankers contacted over 50 potential acquirors but received little meaningful interest. Meanwhile, NCS’s financial condition continued to deteriorate. In mid-2001, Omnicare, Inc. ("Omnicare") proposed to acquire NCS’s assets in bankruptcy at a price insufficient to repay NCS’s debt, let alone provide any return to NCS’s stockholders. Omnicare told NCS at this time that it was not interested in any transaction other than an asset sale in bankruptcy.
By early 2002, NCS’s financial situation had begun to improve. In May 2002, NCS began speaking with Genesis Health Ventures, Inc. ("Genesis") about a possible transaction. Significantly, Genesis had previously lost a bidding war on a different transaction to Omnicare and was adamant that any transaction with NCS must include mechanisms ensuring its consummation. In June 2002, Genesis proposed a transaction that included the full repayment of NCS’s secured debt, a significant payment to NCS’s stockholders, and the assumption of NCS’s other liabilities and unsecured debt.
In the meantime, Omnicare began to suspect that another potential acquiror was engaging in merger discussions with NCS. In late July 2002, Omnicare offered, for the first time, a proposed acquisition of NCS outside of the bankruptcy context. However, the proposal contained several troubling "outs," such as the receipt of several third-party consents and the satisfactory completion of due diligence. NCS used the Omnicare proposal to obtain substantial improvements in the terms of the Genesis offer. Genesis, however, stipulated that the deal had to be approved within twenty-four hours or it would withdraw its offer and walk away.
Upon consideration of the improved Genesis deal terms, the uncertainty of the Omnicare proposal, and the possibility of losing the Genesis offer, a special committee of NCS’s independent directors voted unanimously to recommend the Genesis proposal to the full NCS board. The NCS board likewise approved the Genesis deal. The relevant deal terms provided:
that NCS would submit the merger agreement to a vote of its stockholders, regardless of whether the board withdrew its recommendation, as permitted by Section 251(c) of the Delaware General Corporation Law; that NCS would not enter into discussions with third parties regarding an acquisition unless, among other things, the proposal was unsolicited and likely to result in a superior deal; and that, as a condition precedent to the execution of the merger agreement, two NCS stock holders who collectively owned over 65% of the voting stock of NCS would sign irrevocable agreements to vote in favor of the deal.
The obvious result of these terms was that, even if the NCS board later received a superior offer and withdrew its recommendation of the Genesis deal, Genesis had at least 65% of the votes locked up, and NCS had no ability to terminate the Genesis deal and accept the superior offer.
After the Genesis merger agreement was signed, Omnicare made a new and unconditional proposal to acquire NCS at more than double the price per share that Genesis was offering. As a result, the NCS board withdrew its recommendation in favor of the Genesis transaction. NCS’s investment bankers likewise withdrew their fairness opinion of the Genesis merger. However, because of the voting agreements and the Section 251(c) "force the vote" provision, these actions were powerless to block completion of the Genesis deal. Thereafter, Omnicare filed suit to enjoin consummation of the Genesis transaction. In November 2002, the Delaware Chancery Court rejected Omnicare’s challenge and upheld the deal protection devices. In December 2002, the Delaware Supreme Court issued a summary order reversing the lower court’s ruling. Four months later, the Court issued the full text of its decision.
The Majority Opinion
While the Delaware Supreme Court assumed that the business judgment rule properly applied to the NCS board’s initial decision to merge with Genesis, it held that the NCS board’s adoption of defensive devices designed to ensure the consummation of the merger was subject to enhanced scrutiny under Unocal v. Mesa Petroleum Co. The Unocal test is two-pronged. First, the NCS directors must demonstrate "that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed . . . ." The Court assumed without ruling that this prong of the test was satisfied, because the NCS board believed that Genesis would withdraw its proposal—leaving NCS with no acceptable alternative—if it was not granted adequate assurance that the deal would be accomplished.
Second, the NCS directors must demonstrate that the measures they adopted were "reasonable in relation to the threat posed." This, in turn, involves a two-step analysis. The directors must demonstrate: (1) that the protective devices were neither "coercive" nor "preclusive;" and (2) that their response was within a "range of reasonable responses" to the perceived threat. The Court determined that the "tripartite" protective devices adopted by the NCS board were both preclusive and coercive because they "accomplished a fait accompli." That is, these measures made it "mathematically impossible" for any transaction other than the Genesis merger to succeed, no matter how attractive the terms or how superior the proposal. Because the predetermined and locked-up nature of the deal rendered any stockholder vote irrelevant, the deal protective devices were also held to be outside the range of reasonable responses to the perceived threat of losing the Genesis deal.
The Court also invalidated the protective measures on the alternative ground that they prevented the board from exercising its continuing fiduciary duties to NCS’s minority stockholders. The Court held that when a stockholder vote is locked up, the board must negotiate a sufficient fiduciary out to protect the minority stockholders in the event that the offer on the table is eclipsed by a superior offer. The ineffective fiduciary out, combined with the stockholder voting agreements, did not fulfill this requirement, because it could not prevent the Genesis deal from being submitted for a stockholder vote, the result of which was a foregone conclusion.
In strongly worded dissents, Chief Justice Veasey and Justice Steele called for a narrow construction of the ruling going forward, because the Court’s bright line rule could chill the interest of future bidders who want certainty in their negotiated transactions and cause a corresponding drop in value enhancement in the market.
What Does it Mean?
The Omnicare decision makes clear that, no matter how dire the financial situation of a target, and no matter how extensively shopped the deal is, a combination of protective measures that irrevocably locks up a merger transaction will be subject to close judicial scrutiny and may prove difficult to defend. In this case, it was the combination of the locked-up stockholder vote, the "force the vote" provision, and the lack of any effective fiduciary out that proved fatal. The Court stated that any one of these defensive measures in isolation would be permissible, so long as it provides a meaningful fiduciary out, but plainly a combination of the three is not permissible.
What is unclear from the Court’s decision is whether some other combination of defensive measures or some variation of each of the NCS defensive measures would be permissible. For example, would it be permissible to have a Section 251(c) provision and less than a majority of stockholders locked up, or is the lock-up percentage irrelevant if the board is required to put the merger to a stockholder vote and has no effective fiduciary out? Also unclear is whether the Court would approve if the stockholders of a private company had agreed among themselves (at the time of their investment in the company and not in connection with any deal currently on the table) to certain drag-along rights (which require all stockholders to vote for a merger if a majority of a particular class of stock votes for the merger), and these drag along rights are exercised in a later-proposed merger in combination with a "force the vote" provision and no other effective fiduciary out. Although the Omnicare dissenters expressed hope that the Court’s holding will be confined to the unique facts of the case, it remains to be seen how that holding will be construed by the Delaware courts.
For now it is clear that, going forward, the Delaware courts can be expected closely to scrutinize the availability of fiduciary outs in business combination transactions involving Delaware companies. (The impact of this case on companies not incorporated in Delaware is unclear; while the courts of other states are strongly influenced by Delaware corporate law, they are not required to follow this decision.) The terms of such fiduciary out provisions—including how they are triggered, how long they last, and what steps they permit target companies to take—will continue to be intensely negotiated. Indeed, we expect that this heightened scrutiny of fiduciary out provisions will lead to different market standards for fiduciary out terms, including higher termination fees, as buyers seek to restore a level of certainty to negotiated transactions.
Other long-term ramifications of Omnicare on financing and merger transactions remain to be seen, but the decision’s consequences are potentially far-reaching. We will closely monitor all future developments and provide update bulletins as appropriate.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.