ABA Section of Business Law

What's the big deal?

Delaware looks at boards, stockholders and protecting the agreement.

By JOHN J. JENKINS

W hat happens when it's a case of the stockholders versus the board?

In late 1999, Delaware's Chancery Court began a debate that may result in an important shift in how Delaware courts look at board actions in the M&A arena. If so, then some long-held assumptions about what boards can and cannot agree to in a merger may need to be reassessed.

What's the fuss about? Deal protections. Companies negotiating a merger spend plenty of time and money on the transaction, and want to protect their investment and the opportunity the deal represents to them and their stockholders. Consequently, most merger agreements contain provisions designed to protect the deal from other suitors. A wide array of these deal protections have evolved, including various types of "no-shop" clauses, termination fees, stock options and stockholder lock-ups.

Cases dealing with defensive measures and the special responsibilities of the board when a corporation is "for sale" (see Delaware sidebar) have made crafting deal protections a delicate balancing act. But until recently, most lawyers were pretty comfortable about how far they could go and how courts would look at what they had done. They are much less comfortable now.

Chancellor William Chandler fired the first volley in the deal protection debate with his ruling in Phelps Dodge v. Cyprus Amax, C.A. No. 17398 (Del Ch. Sept. 27, 1999). In that decision, the chancellor invalidated a "no-talk" clause contained in a merger agreement between Cyprus Amax and Asarco. Unlike typical "no-shop" clauses, which allow discussions with other bidders in limited circumstances, this no-talk clause prohibited those discussions altogether. In striking down the clause, the chancellor observed that while neither party to this Time-Warner deal had to negotiate with another bidder, the decision not to negotiate had to be an informed one. The no-talk provision was invalid because it prevented that from happening. Id.

ACE Limited v. Capital Re, C.A. No. 17488 (Del. Ch. Oct. 25, 1999), picked up where Cyprus Amax left off. This time, the issues arose out of the battle for Capital Re Corp., a specialty reinsurer, between ACE Limited and XL Capital. In June 1999, ACE and Capital Re entered into a merger agreement. On the day before Capital Re's stockholders meeting, XL Capital made an all-cash offer to buy Capital Re. The meeting was postponed, and Capital Re decided to terminate the ACE deal and to accept XL Capital's offer. ACE then sued Capital Re for breaching the merger agreement's no-shop clause.

When the merger agreement was signed, stockholders owning 33.5 percent of Capital Re's shares also signed voting agreements with ACE, which itself held about 12.5 percent of Capital Re's shares. These agreements bound the stockholders to vote for the ACE deal, but contained an out that would be triggered if the Capital Re board terminated the merger agreement.

The merger agreement allowed Capital Re's board to terminate the deal to accept a superior proposal. It also contained a tightly drawn "no-shop" clause that allowed Capital Re to talk to another bidder, but only if several conditions were met. ACE's position on the no-shop clause was that the Capital Re board could negotiate only if its lawyer opined in writing that it had to do so. Vice Chancellor Leo Strine disagreed, but acknowledged that ACE's interpretation was plausible, and so decided to look at what would happen if ACE's interpretation were correct.

The vice chancellor said that if the no-shop clause meant what ACE said, then by agreeing to it, the Capital Re board abdicated its duty to make its own decision about what its fiduciary duties require. Id. at 27. While acknowledging that a board sometimes might be able to agree not to entertain a superior proposal, Strine said that the circumstances of this case "would not seem to be of that nature." Id. at 28. He emphasized the effect of the voting agreements, noting that "the board's inability to consider another offer in effect precludes the stockholders (including the 33.5 percent holders) from accepting another offer." Id.

At this point, the Chancery Court seemed to have a consistent position on deal protections, albeit one that probably surprised many lawyers. While a board's decision to enter into a Time-Warner strategic merger would be shielded by the business judgment rule, deal protections would be reviewed under what was said to be the Unocal standard, but that in some respects — in particular the emphasis on the board's need to be able to consider a better deal — sounded a lot like Revlon and QVC.

These two decisions alone would have given lawyers and boards plenty to chew on. But things were about to get even more interesting.

Just two days after Capital Re, the Chancery Court took a different approach to a case involving many of the same issues. This time, it was Vice Chancellor Myron Steele's turn to weigh in on deal protections.

In Re IXC Communications Inc. Shareholders Litigation, C.A. No. 17324, (Del. Ch. Oct. 27, 1999) arose out of a pending merger between IXC Communications Inc. and Cincinnati Bell Inc. IXC began looking for a merger partner in early 1999. Cincinnati Bell entered the picture in late May, and after extended negotiations that included IXC's largest stockholder, the GE Pension Trust, the parties entered into a merger agreement on July 20, 1999.

The Trust was brought into the negotiations because Cincinnati Bell wanted its support of the deal. The Trust agreed to do so, but only if Cincinnati Bell cut a side deal with it and agreed to buy half of the Trust's IXC stock.

The merger agreement's other deal protections included a no-talk clause, which was later amended to allow either side to consider "superior proposals." The agreement also contained a termination fee and a cross-option agreement.

Vice Chancellor Steele dismissed allegations that the no-talk clause amounted to "willful blindness" by observing that clauses like these were common and did "not imply some automatic breach of fiduciary duty." Id. at 14. Steele also was unimpressed by claims challenging the agreement's other deal protections. In a departure from his colleagues' approach to deal protections, the vice chancellor assessed these issues entirely by reference to the business judgment rule. Id. at 23.

The vice chancellor also rejected contentions that the side deal with the Trust represented illegal vote buying. Steele said that vote-buying arrangements are only illegal if they work to disenfranchise or defraud other stockholders. Otherwise, he held that "a shareholder may commit his vote as he pleases." Id. at 18.

IXC seems hard to reconcile with Capital Re. Both cases involved merger agreements with no-shop provisions supported by formidable stockholder lock-ups. Neither case implicated Revlon duties, but while one judge evaluated the deal protections in the merger agreement under what was arguably a "super-Unocal" analysis, the other assessed similar deal protections by reference to the business judgment rule.

The contrasting approaches to these two cases suggest that there are significant differences among the members of the Chancery Court on the standard of review for deal protections. But maybe the judges are not as far apart as they seem. Perhaps what cases like Capital Re suggest is an increasing concern about how board-approved deal protections affect stockholder voting rights. If so, then maybe IXC does not contradict Capital Re, but instead serves as a counterpoint to it.

Protection of stockholder voting rights is not a new concept, and prior Delaware case law is full of statements about the sanctity of the franchise. In 1995, the Delaware Supreme Court warned that defensive measures "designed to thwart the essence of corporate democracy by disenfranchising shareholders" would be suspect under Unocal. Unitrin v. American General Corp., 651 A.2d 1361, 1378-1379 (Del. 1995). When a board acts with the primary purpose of interfering with the stockholders' voting rights, that decision will not be assessed under Unocal, but under the test established in Blasius Industries v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988), which requires the board to demonstrate a "compelling justification" for its actions. See, for example, Williams v. Geier, 671 A.2d 1368, 1376 (Del. 1996).

Blasius and Unocal have a complicated relationship. In practice, courts seldom invoke Blasius' compelling-justification test, and disenfranchisement claims rarely carry the day in Unocal cases. Unitrin itself illustrates this point.

After citing Blasius and noting the "special import of protecting the shareholder franchise" in assessing defensive measures under Unocal, the Delaware Supreme Court upheld a stock repurchase program initiated in response to a hostile tender offer and proxy contest. Ironically, the court did not express much concern about disenfranchisement, even though the repurchase program would have placed almost 30 percent of the stock in friendly hands and made a successful proxy contest very unlikely. Instead, the court emphasized the "substantial latitude" that boards have under Unocal to adopt reasonable defensive measures. Unitrin at 1388, n. 38.

Cyprus Amax and Capital Re suggest that stockholder voting rights may be moving to center stage in some judges' assessment of deal protections. Another recent Chancery Court decision provides additional support for this hypothesis.

In Chesapeake Corp. v. Shore, C.A. 17626 (Del. Ch. Feb. 7, 2000), Vice Chancellor Strine highlighted the incongruities in the Unitrin opinion and discussed the complex relationship between Blasius and Unocal. He noted that there would be less need for Blasius if Unocal were applied "with a gimlet eye out for inequitably motivated electoral manipulations or for subjectively well-intentioned board action that has preclusive or coercive effects." Id. at 66. He said that the optimal solution might be for the Chancery Court to "infuse our Unocal analyses with the spirit animating Blasius and not hesitate to use our remedial powers where an inequitable distortion of corporate democracy has occurred." Id. at 66.

Another look at Capital Re indicates that Strine's Unocal analysis in that case was indeed "infused with the spirit animating Blasius." With 46 percent of the vote locked up unless the board acted, ACE's interpretation of the no-shop clause effectively precluded stockholders from voting down that offer.

Strine concluded that a board did not have unlimited authority to negotiate a merger agreement linked to voting agreements "ensuring consummation if the board does not terminate the agreement," regardless of whether the board no longer believed that the merger was a good deal. Capital Re at 29. With voting agreements like these in place, the board could not agree to "sit idly by and allow an unfavorable and preclusive transaction to occur that its own actions have brought about." Id. at 29-30.

But why should the vice chancellor have cared about the voting agreements at all? Unocal applies only to unilateral board action, and Delaware courts repeatedly have said that stockholders are free to do as they like with their own shares, so why worry about the voting agreements?

The reason appears to be the link between those agreements and the merger agreement. The parties could have unconditionally committed themselves to the deal, but they didn't. Instead, they agreed to vote for the transaction, but only if the board did not terminate the merger agreement. Their commitments were directly linked to the board's continued support of the deal, and only action by the board could release them from their obligations.

In contrast, the arrangements between the GE Pension Trust and Cincinnati Bell in IXC involved unilateral stockholder action. The Trust cut its own deal, without involving the board. Although the Trust's voting agreement also terminated if the merger were terminated, unlike Capital Re, IXC's board could not terminate the merger agreement to accept a better deal — a fact that the Trust knew going in.

Under these circumstances, perhaps it isn't surprising that Vice Chancellor Steele dismissed disenfranchisement claims predicated on the side deal by saying that stockholders may vote as they please. IXC at 18. The Trust's side deal may have been a formidable barrier to a competing offer, but it was one that the vice chancellor seemed to think a stockholder dealing with its own property — as opposed to director-fiduciaries dealing with other people's property — had the right to erect.

From this perspective, Capital Re looks like a case where the link between the voting agreements and the merger agreement prompted concerns that board-authorized deal protections could effectively disenfranchise stockholders. On the other hand, IXC looks like a case where any barriers to a competing deal were erected by a stockholder acting independently. While inconsistencies remain, the two decisions seem less irreconcilable when looked at in this way.

Even if Capital Re and IXC are reconciled, two important questions remain. First, why have concerns about the effect of deal protections on voting rights suddenly become more prominent? Second, what would a change like this mean for parties trying to build enforceable deal protections into their merger agreements?

The answer to the first question may lie in the 1998 amendment to Section 251(c) of the Delaware General Corporation Law. That amendment allowed directors to agree to present a merger to the stockholders, even if they could no longer recommend it. This change in the law did not escape Vice Chancellor Strine's attention. In Capital Re, he observed that if the Capital Re board took the approach authorized by Section 251(c), the result of the vote would be "foreordained" without an out for the parties to the voting agreements — an out that only the board could provide. Capital Re. at 36, n. 55.

Strine suggested that it might be a different matter to agree to put a merger agreement to a vote "if there are no other provisions tied to the agreement that operate to preclude the stockholders from freely voting down the merger." Id. at 26, n. 34. So perhaps the board's ability to submit a transaction to stockholders that it can no longer recommend has "upped the ante" for deal protections that impinge on the stockholders' ability to vote that deal down.

It is hard to give a definitive answer to the second question, but a shift in the way courts look at deal protections could produce some surprising results. For example, one of the ironies of Capital Re and IXC is that these cases suggest that stockholder lock-ups that do not involve the board may be more defensible than those that terminate based on board action. In other words, the problem with some stockholder lock-ups may be that they just are not preclusive enough.

Assessing the reasonableness of deal protections by their effect on the stockholder franchise also could result in a different approach to termination fees. Traditionally, the debate on termination fees has focused on the size of those fees. But if Unocal's emphasis shifts to the effect of deal protections on voting rights, then perhaps boards will have more latitude on the size of termination fees, if they pay close attention to when those fees become payable.

That possibility was hinted at earlier this year, when Vice Chancellor Strine rejected claims that a termination fee at "the high end of what our courts have approved" was an impermissible impediment to a competing bid in a Revlon deal. McMillan v. Intercargo, C.A. No. 16963 (Del. Ch. April 20, 2000). In so doing, he emphasized that the fee was payable only if the stockholders turned down the deal and the company later made another deal. Strine thought that this structure ensured that "stockholders would not cast their vote in fear that a ‘no' vote alone would trigger the fee..." Id. at 27.

If the Chancery Court's emphasis in these cases really is changing, the results may be a bit of a mixed bag for boards and their lawyers. Some types of deal protections may be more defensible, others less defensible. The level of scrutiny applied to deal protections may depend less on whether the deal is cast as a Time Warner or a Revlon transaction, and more on the extent to which those protections impinge on the stockholders' franchise. That may make things more interesting, but as the debate over deal protections illustrates, things rarely are boring in the Chancery Court.

 

Jenkins is a partner at Calfee, Halter & Griswold, LLP, in Cleveland. His e-mail is: jjenkins@calfee.com