In class yesterday, we tackled the Delaware supreme court's decision in Omnicare v. NCS Healthcare, 818 A.2d 914 (Del. 2003), in which the Delaware supreme court held that an exclusive merger agreement -- such as a no shop or best efforts clause -- must include a fiduciary out, at least where the agreement presents target shareholders with a “fait accompli.” No Delaware court has yet offered a persuasive reason for their hostility to no shop clauses and the like. Instead, the invalidity of such strategies has been asserted by mere fiat. If Omnicare proves anything, it proves that the Delaware supreme court's fiat is not infallible.
NCS was an insolvent health care company considering a “pre-packaged” bankruptcy reorganization. Omnicare, a competitor health care firm, offered to acquire NCS’ assets for $225 million (later raised to $270 million and then to over $313 million) in a bankruptcy sale pursuant to § 363 of the Bankruptcy Code. Omnicare’s proposal was substantially less than NCS’ outstanding debt, which meant that NCS’ shareholders would get nothing and many creditors would be paid only in part. Negotiations broke down and were discontinued.
A few months later NCS was approached by Genesis, another health care firm. Genesis proposed a merger that would have paid off most of NCS’ creditors in full, provided substantial recovery for holders of NCS’ notes, and given NCS’ shareholders a small return on their investments. NCS formed a special committee of independent directors to conduct the negotiations. Because Genesis had lost a prior bidding war to Omnicare, Genesis insisted on an exclusivity arrangement pursuant to which NCS would not conduct merger negotiations with any other potential bidder while the negotiations between NCS and Genesis were underway. When Omnicare tried to reopen negotiations, the independent committee decided to honor the exclusivity agreement with Genesis because they believed there was a substantial risk that Genesis would walk away from the deal, allowing Omnicare to press its bankruptcy sale plans.
In light of Omnicare’s bid, NCS’ independent directors did extract significantly better terms from Genesis. In return, however, Genesis’ insisted on substantial deal protections. First, it required a termination fee of $6 million. Second, NCS’ board agreed to submit the Genesis deal to a shareholder vote even if the board withdrew its recommendation that the shareholders approve the deal. Third, the agreement contained a no shop clause. Finally, Genesis insisted on a shareholder lockup.
The shareholder lockup was possible because two shareholders had a majority position. NCS had two classes of common stock. Class A was standard common with one vote per share. Class B was super-voting rights stock with 10 votes per share. The vast majority of the Class B stock was owned by NCS’ board chairman and its CEO. The chairman and CEO thereby had effective voting control of NCS. At Genesis’ insistence, the chairman and CEO agreed to vote in favor of the merger. NCS was a party to that agreement, apparently to validate it under Delaware’s antitakeover statute.
In combination, these provisions presented the minority shareholders of NCS with a fait accompli. There was no way they could reject the deal as long as the two controlling shareholders voted for it, as they were obliged to do. When Omnicare nevertheless made a higher offer to acquire NCS, Omnicare and some NCS shareholders sued to invalidate the agreement.
By a 3-2 vote, the Delaware supreme court struck down the NCS-Genesis merger agreement. In his dissent, Chief Justice Veasey noted that “[s]plit decisions by this Court, especially in the field of corporation law, are few and far between.” 818 A.2d at 940 n.90. There is a strong unanimity norm in that court. David A. Skeel, Jr., The Unanimity Norm in Delaware Corporate Law, 83 Va. L. Rev. 127 (1997). The willingness of Justices Veasey and Steele to dissent indicates the high profile nature of the Omnicare decision.
The majority acknowledged that “[a]ny board has authority to give [a bidder] reasonable structural and economic defenses, incentives, and fair compensation if the transaction is not completed.” In addition, the majority acknowledged that the controlling shareholders “had an absolute right to sell or exchange their shares with a third party at any price.” Yet, the majority nevertheless concluded that NCS’ board “was required to contract for an effective fiduciary out to exercise its continuing fiduciary responsibilities to the minority stockholders.”
The court based that requirement on a notion that the board has an on-going fiduciary duty to constantly reevaluate its decision. The court’s initial order stated that the measures at issue in that case were preclusive because, “[i]n the absence of a fiduciary out clause, [they] precluded the directors from exercising their continuing fiduciary obligation to negotiate a sale of the company in the interest of the shareholders.” When the court later issued its full opinion, the court again advanced the pernicious notion that the board must “discharge its fiduciary duties at all times” even “as circumstances change.” In dissent, Justice Steele aptly criticized the majority for adopting “proscriptive rules that invalidate or render unenforceable precommitment strategies negotiated between two parties to a contract who will presumably, in the absence of conflicted interest, bargain intensely over every meaningful provision of a contract after careful cost benefit analysis.”
I find the Delaware court’s hostility to no shops and other forms of exclusive merger agreements very puzzling. As I discussed in an earlier post, precommitment strategies are commonplace. Think of Odysseus lashing himself to the mast so that he can hear the Sirens’ song without running his ship aground. Hostility to precommitment strategies certainly does not follow a fortiori from the mere fact that directors are fiduciaries. Why should informed directors acting in good faith not be allowed to lash themselves to the mast of a particular deal? Case law in other jurisdictions allows them to do precisely that. See, e.g., Jewel Cos., Inc. v. Pay Less Drug Stores Northwest, Inc., 741 F.2d 1555 (9th Cir. 1984), which specifically validated no shop clauses by permitting the target’s board to “lawfully bind itself in a merger agreement to forbear from negotiating or accepting competing offers until the shareholders have had an opportunity to consider the initial proposal.” Id. at 1564.
The Jewel approach makes much more sense than that of Omnicare. Suppose the board of directors makes an informed decision that the merger proposal on the table is the best deal they are likely to get for their shareholders and that granting a no shop clause is necessary and appropriate to induce the prospective acquirer to make a formal bid. The board recognizes that a no shop clause will impede its ability to negotiate with any competing bidders who subsequently emerge, but the board decides to accept that risk and go forward. In doing so, the board relies on the old adage that a bird in the hand is worth two in the bush. So long as the decision to enter into the no shop clause was an informed one, why should a board of directors have an on-going fiduciary duty to constantly reevaluate its decision?
Reference: Mergers and Acquisitions at 189-91 and 367