Cooley M&A Team News - January 2016

M&A Team News
January 2016


Top 10 M&A developments and trends for 2016
Here is a look back at the top M&A developments that affected deal-making last year and a look forward to our expectations for 2016.

Judicial developments

Agreements to agree can be broken: negotiating letters of intent
SIGA breached its express agreement when, after terminating the merger agreement at the end date when the conditions to closing had not been satisfied, it proposed terms that differed dramatically from those set forth in the term sheet.

No harm, but foul: process considerations for "interested" transactions
A 2002 recapitalization of a streaming media start-up unfairly diluted the minority stockholders when VC-backed directors failed to include the stockholders in an emergency round of financing that benefited the VC funds after the company was later sold.

Mind the gap (or lack thereof)
Two recent cases regarding earn-outs make one thing clear: express language in the definitive agreement prevails over any implied covenant of good faith and fair dealing.

DE Supreme Court upholds banker liability for inducing faulty process in Rural/Metro sale
The Court upheld principal rulings finding financial advisor RBC Capital Markets liable for approximately $76 million in damages for aiding and abetting breaches of fiduciary duties by former directors of Rural/Metro Corporation.

Recent publications

Revised 2016 Hart-Scott-Rodino Antitrust Thresholds – Effective February 25, 2016

What US GCs Should Know About Drafting International Arbitration Clauses

Top 10 Antitrust Developments and Trends to Watch in 2016

UK Supreme Court Confirms Merger Control Threshold for Business Acquisitions

Proposing a Fix? Ready to Litigate the Fix? Recent Cases Should Guide Strategy

High-Tech Mergers: Flying "High" on the Antitrust Enforcement Radar


Recent transactions

(includes pending transactions)

 AddThis acquired by Oracle


Top 10 M&A developments and
trends for 2016

Here is a look back at the top M&A developments that affected deal-making last year and a look forward to our expectations for 2016.

Happy New Year M&A!

2015 witnessed an all-time high in M&A deal value at over $5 trillion, according to Dealogic. The high volume was primarily attributable to strategic megadeals that used stock as full or partial consideration, with healthcare and technology as the two most targeted industries.

In 2016, we continue to expect to see heavy M&A volume in healthcare with similar drivers. Big pharma will likely continue to try to fill product pipelines as high-revenue drugs go off patent (they seem to favor orphan, specialty and cancer drugs for hard to cure indications or for patient populations that are refractory to first line therapy). Specialty pharma may continue to compete for approved drugs that are underperforming where commercial execution can be improved. And development-stage life science companies will continue to consider M&A among its strategic alternatives in light of the challenges involved with transitioning from a development-stage company to a commercial drug company. Inverted pharma companies are likely to continue to use tax rate differences to create synergies that drive acquisitions.

In tech, M&A deal volume remained consistent but largely under the radar in 2015. Larger private and public companies continued to acquire talent and valuable assets, on generally favorable deal terms (if not valuations), but often on a smaller scale than anticipated. Because the public and private capital markets remained open for a large part of last year, many successful private companies retained pricing leverage over buyers or continued to prioritize IPOs over M&A exits – which may have depressed transaction volume. This year, with the volatility in the capital markets (and the unicorn phenomenon becoming more uncertain), we expect these companies and their institutional backers to be more receptive to M&A in 2016. We also note that large cap tech companies still have substantial cash on their balance sheets that can be used for acquisitions if targets become more affordable.

Private equity buyers, which have been relatively quieter in the markets due to high valuations, will likely be more active in 2016, as they seek new opportunities to buy unwanted assets or businesses (including those needing to be divested) from strategics. We also expect PE-to-PE sales and incremental add-ons to continue, assuming no major upheaval in the debt markets – a big assumption in the current environment.

We also expect cross-border M&A activity to continue unabated at high levels of volume in 2016 as deal makers continue to take advantage of, among other things, tax optimization and efficiency, fluctuations in currency prices (particularly in China) and pricing arbitrage from one country to another.

Who's afraid of the big bad wolf?

Activism continues to fuel M&A, with breakups, divestitures and sales constituting the fastest growing type of requests by activists over the past five years by far. Activists are waging campaigns for deals even where regulatory concerns would normally be seen as a gating factor (Starboard/Office Depot, Elliott/Dollar Tree). We witnessed activists willing to confront even the largest companies and to engage on even signed deals (Elliott/Atmel, Icahn/Pep Boys).

In contrast to the "wolf packs" of old, activists no longer comprise only hedge funds but also family offices and traditional institutional investors. Moreover, activists no longer feel the need to acquire large stockholdings in order to push for their agenda. As a result, even the threat of activism plays a large role in boards' review of strategic alternatives (both buy- and sell-side) on a more regular basis than in years past.

In a shift, boards' reactions appear to have diversified from being solely defensive to more inclusive, with campaigns tending to settle relatively quickly and with about 36% (up from 30%) of all activist campaigns launched in 2015 resulting in board seat(s), according to FactSet Research.

Most companies by now have investor outreach efforts and corporate response strategies in place. Going forward – and particularly if private ordering for proxy access continues to swell – boards will need to focus on how best to govern their companies with dissenting voices in the boardroom. This will require attention, among other things, on board confidentiality and fiduciary duty issues related to the presence of dual-fiduciaries on the board and, potentially, managing and disclosing compensatory arrangements between the activist and its board member(s).

Drawing the path to closing when antitrust concerns are high

As we recently discussed in this alert, a number of prominent deals in 2015 were blocked by the DOJ, fueling already-deep concerns that tie-ups with competitors will be closely scrutinized. Even smaller deals – particularly in the technology sector – are drawing attention.

This concern for deal certainty has resulted in increased attention to the sharing of potentially sensitive information during the due diligence process and has resulted in increased legal review of board materials at the earliest stages of the transaction. In addition, the concern for deal certainty has also resulted in increased negotiation of the various "efforts" covenants that are often contained in merger agreements. These covenants define the level of efforts or action that a purchaser will take (e.g., "any and all steps," "reasonable best efforts," "no action" or variations in between) to eliminate antitrust objections or obtain the required antitrust approvals. In addition, more and more sellers are requesting that buyers agree to a "reverse" break-up fee if the transaction fails to close because of antitrust concerns in order to motivate the buyer to address those concerns and help compensate the seller in the event the deal fails to close, and "ticking fees" that increase the longer it takes to address antitrust concerns, to speed up the process. Other covenants restrict the actions that a purchaser can take between the signing and the closing which could exacerbate antitrust problems, such as acquiring certain assets or businesses.

With the high level of antitrust scrutiny expected to continue, parties will likely continue to flesh out purchasers' obligations in merger agreements. There has been some concern that including detailed efforts covenants in a merger agreement might itself provide a "roadmap" for regulators to identify problematic lines of businesses or assets that need to be divested. In some cases where antitrust concerns are obvious, their value may well outweigh that risk. In certain recent deals where antitrust scrutiny was expected, the DOJ rejected the parties' pre-negotiated divestiture package as insufficient, suggesting that a provision that may be seen as providing certainty does not always do so.

Reverse break-up fees, which have been highlighted by recent and prominent payouts, will likely continue to be requested. As deal values have soared, the fee amounts have increased. The amount of these fees as a percentage of deal value, however, has not changed and has generally ranged from 2%–20%, but may be higher.

The expected level of antitrust scrutiny may also play a factor in what deal structure to choose. In addition to the regulatory environment that at times may seem hostile to merger parties, there is also a significant level of hostile deal activity that has resulted in signed deals being jumped by bidders offering competing proposals. If a buyer expects a long regulatory-review period, it may be better to structure the deal as a statutory merger than as a tender offer because once the target's stockholders have approved the deal the exposure to a hostile bid is eliminated, regardless of how long it takes to obtain regulatory approvals and eventually close.

Did you say bankers have conflicts?

The Delaware courts continue to focus on financial advisor conflicts and the need for boards to identify, vet and manage their advisors' actual and potential conflicts in a sale process. The more recent decisions focus on the need to address current and historical conflicts prior to engagement – particularly if financial analyses are presented – and to address them in representations, warranties and covenants in engagement letters. In addition, boards should establish processes to remain informed of any current or developing conflicts throughout the transaction and to disclose them to stockholders. It will be interesting to see how this practice evolves in light of the understandable difficulty in identifying which of the bankers' relationships and discussions (some of which may be necessary to facilitate the deal) need to be disclosed. What is clear is that boards need to be proactive and diligent with respect to their financial advisor conflicts but that an informed decision to proceed with an engagement in spite of a perceived conflict that honors best practices should not affect the legitimacy of the engagement. There is also continuing heightened focus on attention to financial projections and company metrics that underlie the advisor's work or fairness opinion.

Big things can come in small packages: no gatekeeper liability for advisors

Late last year, the Delaware Supreme Court upheld rulings finding a financial advisor liable for approximately $76 million in damages for aiding and abetting breaches of fiduciary duties by former directors of Rural/Metro in connection with the company's 2011 sale to a private equity fund. Despite finding that the financial advisor was liable for aiding and abetting based on its effective fraud on the board, the opinion also explained that the decision should be read narrowly and disavowed the notion that financial advisors, as experts, should serve as "gatekeepers" for the board. The Court explained that the role of a financial advisor is primarily contractual in nature and is typically set forth in the engagement letter. It then clarified that a financial advisor cannot be found liable for failing to prevent a board from breaching its fiduciary duties. Although this language was contained in a footnote to the opinion, it was a big development for financial advisors that is sure to be cited in conflicts cases to come.

Dissenters need not dissent: appraisal arbitrage continues

Last year, the Delaware legislature amended the appraisal statute to try to discourage appraisal arbitrage as an investment strategy but failed to adopt a share tracing requirement, which continues to allow investment funds to seek dissenters rights for shares bought after a deal's announcement that were not actually voted against the merger due to the fact that most shares are held in fungible bulk through DTC. These investment funds buy shares after the announcement of a deal and file an appraisal claim with the hope of a court judgment at a higher price than the merger price. In addition, arbitrageurs also hope to benefit from the provision in the appraisal statute that guarantees an interest payment (5% plus the Federal Reserve discount rate compounded monthly) on the appraised amount from the time of the merger until the judgment is paid, regardless of whether the appraised value is higher than the merger price.

In 2015, a number of appraisal decisions found that a fully-negotiated merger price (and not an independent valuation by the court) is the best indicator of fair value in cases where there was a fair and robust sale process at arms-length, and held that the merger price was the fair value of the appraised stock (, Ramtron, BMC Software). With these recent decisions as precedent and the rise of interest rates (which makes the interest rate strategy less attractive), arbitrageurs may eventually decide to move on. However, because appraisals continue to have settlement value, they will likely continue as an investment strategy for these funds in the near term.

Minding the gap

Earn-outs as a form of consideration appear in a minority of deals. In many industries such as in life sciences where the viability and profitability of a significant asset is uncertain, some form of contingent consideration is standard to bridge the valuation gap and allocation of risk between a buyer and a seller. In particular, acquisitions of private life science companies often have a substantial component of the overall deal value in contingent milestones. In some cases, disputes may develop over whether buyers have proceeded with the development of a product in the manner or on the timetable that a party anticipated when the milestones were negotiated. This may lead to post-closing disputes over whether a buyer used the appropriate level of effort to attain the given milestone or whether milestones have been satisfied, which often result in some form of renegotiation with the seller representative.

Last year, the Delaware Supreme Court in Qinetiq confirmed that unless an agreement expressly requires a higher level of effort, a buyer has no independent obligation or implied covenant of good faith to try to maximize value or trigger an earn-out and that a buyer's obligations will be interpreted based on the plain language in the contract. The Court held that because the contract merely prohibited the buyer from acting "with the intent of reducing or limiting [the earn-out payment]," the buyer did not breach the contract when it failed to meet revenue targets for the given product because it did not intend to reduce or limit the earn-out, even though the buyer may have known that its actions would have resulted in the failure to achieve the milestone. The decision adds to an earlier 2015 Chancery Court ruling that similarly held that the earn-out language meant what it said and that the implied covenant of good faith will not be applied to fill in gaps where they do not exist.

These developments underscore the need for sellers to ensure that the agreement expressly defines what scope of effort and actions a buyer should take to achieve a given milestone, which will depend on the specific facts and circumstances involved but may include a promise to act based on qualitative operational covenants or to take specific, enumerated actions. We are already seeing affected parties heed these warnings.

Private merger structure – binding stockholders

Recent developments affecting private mergers as they relate to minority stockholders have required parties to rethink their choice of structure or develop contractual workarounds.

In the recent Cigna decision, the court held that certain common provisions in the merger agreement were not enforceable against the stockholders that did not sign the agreement. These provisions included the indemnification obligations, a release of claims by sellers against the buyer and the appointment of a sellers' representative. Also last February, in Halpin v. Riverstone, the court found that a drag-along provision in a stockholders' agreement did not prevent minority stockholders from exercising their appraisal rights because the company technically failed to comply with the advance notice requirement in the provision. Interestingly, the court also questioned the general enforceability of a waiver of appraisal rights by common stockholders, a provision that is commonly included in the stockholders' agreements of many VC- and PE-backed companies. The court noted that unlike the holders of preferred stock, whose rights are grounded in contract, the rights of common stockholders vis a vis the corporation and its directors are grounded in statute and common law and, therefore, the question of whether common stockholders can contractually waive their statutory appraisal rights in a squeeze-out merger before the fact, is uncertain.

Deal parties have responded to these rulings by considering a variety of contractual workarounds. These include closing conditions that require a high percentage of stockholders (90%) to sign joinders to certain sections of the merger agreement, which also helps to address the appraisal issue. Others have proposed (i) provisions that shift the risk of non-signing stockholders to the consenting stockholders on a pro rata basis through the use of escrows or otherwise or (ii) increasing the size of the escrow to account for the risk of failing to recover from non-signing stockholders. Naturally, sellers often resist these shifting provisions, which have sometimes had the beneficial effect of getting signatories to recruit non-signatories to sign joinders. In stockholders' agreements, companies may continue to request drag-along rights (but with short advance-notice requirements or retrospective provisions) or obtain voting agreements in favor of the company, which could have the same effect as an appraisal waiver. We have seen various other fixes as well but so far no particular fix appears to have emerged as the dominant market practice.

While these workarounds may have disadvantages of their own, due to the difficulty of obtaining 100% participation for many private companies, we expect that parties will continue to prefer structuring their acquisitions as private mergers rather than as a stock purchase.

M&A litigation in private deals generally

We have seen an increasing focus in Delaware courts on private deals generally. After the Trados decisions, deal parties have been careful to ensure that any M&A deal involving a company with preferred stock or a management incentive carve-out has to be structured with the board's fiduciary duties to the holders of common stock in mind. The affirmance of Nine Systems last month also underscores the need to have a fair process as well as a fair price in interested transactions, not just in an M&A deal but even well before during any recapitalization or corporate financing.

Since the Delaware Supreme Court has upheld the use of cleansing devices in Kahn v. M&F Worldwide Corp. and then again in the context of a private merger in Swomley, deal parties that have a controlling stockholder who participates on both sides or gets a benefit that others do not may find it beneficial to structure their "interested" transactions using the informed special committee and majority of the minority devices that were blessed in those cases. If properly used, the deferential business judgment review will apply and any litigation may well be dismissed at the pleading stage. However, any structuring considerations would need to consider the business realities affecting the company, which may ultimately make the use of these devices impractical.

M&A litigation then and now – what better time to review director indemnification

The Delaware courts appear to be trying to address the fact that over the past few years the vast majority of public M&A deals involved some type of stockholder litigation against directors.

In recent months, some notable decisions have served to discourage nuisance litigation by rejecting one popular method of extinguishing a fiduciary duty claim – disclosure-only settlements. In these settlements, target boards agree to amend their proxy statement/tender offer disclosures with additional disclosures in exchange for a broad, global release of claims. Meanwhile, plaintiffs' firms walk away with attorneys' fees for minimal effort. The WSJ reports that in the last quarter of 2015, the number of M&A suits decreased by half on account of these actions.

At the court and legislature's urging, Delaware exclusive forum selection bylaws, which require fiduciary duty claims to be heard in Delaware, are also having an effect in reducing unmeritorious multi-forum litigation. It appears that the bylaws are being adopted on a regular basis with the blessing of at least a few non-Delaware courts and in-play adoptions are occurring with relative frequency as M&A deals are signed.

While the statistics show that M&A litigation has decreased, our experience shows that plaintiffs firms are instead focusing on stronger (or more creative) claims that can be litigated after closing that allege process and disclosure deficiencies in an effort to seek damages. Plaintiffs firms also appear to be filing breach of fiduciary duty claims in other contexts as well such as in compensation and corporate governance. For example, after the recent decision in VAALCO, which held that a "solely for cause" director removal provision was invalid because the company no longer had a classified board, several claims were filed against companies with annually-elected boards with charters or bylaws that contained this provision.

Many of these post-closing claims allege duty of loyalty breaches that can result in directors being personally responsible for the damages. Therefore, now is the time to review director indemnification provisions, including any provisions that provide for advancement to directors for expenses incurred in defending against a claim. Most companies address indemnification in their charter and bylaws but some companies also have standalone agreements with directors that typically do not give the director additional indemnification but may spell out some of the procedural issues that can get sticky in a dispute. Knowing your companies' indemnification obligations will avoid complications down the road and provide assurances to nominees and continuing directors that they are covered.

 Horizon Pharma acquisition of Crealta Holdings  iSight Partners acquired by FireEye  Sazerac acquisition of Southern Comfort and Tuaca  SolidFire acquired by NetApp  Steel Brick acquired by

Judicial developments

Agreements to agree can be broken: negotiating letters of intent

On December 23, 2015, the Delaware Supreme Court held that SIGA Technologies, Inc. cannot avoid paying $113 million in expectation damages (plus interest) to PharmAthene, Inc. for breaching an express agreement to negotiate a strategic license in good faith in accordance with terms set forth in a term sheet. The parties had expressly agreed to enter into the license agreement in a merger agreement, in the event that their proposed merger transaction failed. In a separate opinion issued in 2013, the Court found that SIGA breached its express agreement when, after terminating the merger agreement at the end date when the conditions to closing had not been satisfied, it proposed terms that differed dramatically from those set forth in the term sheet with an improper motive after recent developments suggested that SIGA's antiviral drug for the treatment of smallpox (ST-246) could be much more profitable than anticipated. In this decision, the Court specifically upheld the award of lump sum expectation damages, ruling that because PharmAthene demonstrated the fact of the breach and that there would be an injury (i.e. lost profits), coupled with the wrongful conduct, it did not need to establish the precise amount of damages to receive what it bargained for. An unusual dissent to the opinion argued that only reliance damages should have been paid.

The SIGA decisions continue to have wide implications for companies considering strategic arrangements – particularly in the life sciences sector where companies are often seeking financial help or regulatory expertise for a drug in the developmental stages and the viability, safety, and efficacy of the drug is uncertain. These arrangements are often complex and key business terms frequently need to be sketched out on a preliminary basis before all of the key terms are resolved.

Typically, these preliminary agreements are not attached to a merger agreement as an alternative deal if the merger fails. Rather, they are usually negotiated at the start of a deal as a preliminary, non-binding letter of intent to proceed in good faith toward a final agreement. Agreements to negotiate in good faith may also be contained in non-disclosure agreements prior to commencing due diligence for a potential deal.

While the facts in this case were unusual (and the rulings highly fact-based), the case serves as a reminder that express agreements to negotiate in good faith are enforceable, binding commitments in Delaware and many other states and that the intent of the parties is the key. If there is an express agreement to agree to terms set forth in accordance with a term sheet, the parties may not, in bad faith, propose terms that are "substantially dissimilar" to those contained in the term sheet. The Court suggests that while disagreements over open terms may prevent a party from reaching a final agreement on those terms or on the contract as a whole, a party cannot propose terms that are substantially different from those that were already agreed to. Those terms will serve as a binding guidepost and not merely a "jumping off point" for the negotiations. Therefore, if parties expressly agree to negotiate in good faith, they must remember that they are losing the leverage to reopen the agreed upon terms even if the agreement on those terms was based on a party's wrong assumption that the open terms would be resolved in a certain manner.

The case serves as a practice point that if a preliminary agreement is truly intended to be non-binding, it should include specific language to that effect. This may include language (in the body of the agreement) providing that the terms (or certain terms) set forth therein are included for discussion purposes only and are not binding on the parties. It may also provide that any terms (including economic, timing or other pricing terms), however detailed, are considered "open" and subject to renegotiation and shall have no binding effect on the terms of a definitive agreement or whether any specific term or agreement is reached at all. If a definitive agreement is signed, a properly drafted integration clause should provide that the definitive agreement shall be the only agreement among the parties and supersedes any earlier contracts or understandings.

See SIGA Technologies v. PharmAthene (Del. December 23, 2015) (affirming expectation damages).

See SIGA Technologies v. PharmAthene (Del. May 24, 2013) (affirming liability).

See PharmAthene v. SIGA Technologies (Del. Ch. September 22, 2011) (on liability).


Judicial developments

No harm, but foul: process considerations for "interested" transactions

After over seven years of litigation, the Delaware Supreme Court on December 11, 2015 upheld the Court of Chancery's important decision in Nine Systems, which held that a 2002 recapitalization of a streaming media start-up unfairly diluted the minority stockholders when VC-backed directors failed to include the stockholders in an emergency round of financing that benefited the VC funds after the company was later sold to Akamai Technologies for $175 million. Despite finding that the transaction was unfair and that the board breached its duties of loyalty, the Court of Chancery declined to award any monetary damages because the plaintiff stockholders' equity was worthless at the time of the financing.

Although the directors technically "won" the appeal (since the no-damages award was affirmed), the case highlights the need for VC-backed directors to adhere to their fiduciary duties to all stockholders (common and preferred) and in all contexts where the minority is adversely affected – not just in the M&A exit or change of control transaction. The protracted (and no doubt, costly) litigation involving this transaction also illustrates the potential advantages of using "cleansing" devices to help mitigate the likely litigation risks associated with "interested" deals.

In Nine Systems, the company faced a funding shortage and turned to its insider directors for a cash infusion. Critical to the trial court's decision was the finding that the board was conflicted because the VC-backed directors comprised a majority. It also found that the VC investors, together, had majority control of the company and stood to benefit from the transaction in ways that the minority did not. Because the transaction was "interested," it applied the "entire fairness" standard of review to the board's actions.

In Delaware, if a "controlled" company enters into a transaction where the controller stands on both sides of the deal, "entire fairness" applies. This is the strictest standard under Delaware law and puts the initial burden of proof on the defendants to show that the transaction was objectively the product of both: (1) fair dealing and (2) a fair price. Because a fairness determination necessarily involves fact-finding (e.g., through discovery and trial), a transaction that falls under entire fairness will rarely be dismissed on the pleadings and the costs of litigation and settlement will increase dramatically.

Entire fairness will also apply in other transactions where a controller is involved, even if the controller does not stand on both sides of the deal, if there are other factors that demonstrate that the transaction is "interested." For example, entire fairness will apply if a majority of the board is not disinterested or if an interested director is shown to dominate the board's decisions. Courts have also applied entire fairness when the controller receives a benefit that the other stockholders do not receive, like premium consideration for high-vote stock or a continuing stake in the surviving entity. These scenarios are all too common among private venture-backed companies such as when the company needs a cash infusion and turns to its insiders.

A board can implement certain procedural safeguards to help shift the burden of proof to the challenger when entire fairness applies, such as by using a special committee or conditioning the transaction on the approval by a majority of the disinterested directors. In Kahn v. M&F Holdings (2014), Delaware's highest court held that interested transactions can escape entire fairness review altogether if the transaction uses both cleansing devices, namely, if it is: (1) approved and negotiated by an informed and independent special committee of directors and (2) conditioned at the beginning on the approval by a majority of the disinterested directors. On November 19, 2015, in Swomley, the Court showed that Kahn had teeth when it blessed a deal involving a private company that employed these "MFW"-compliant procedures. The case was dismissed for failing to state a claim.

Whether to employ these devices will depend on the company's business realities, such as the likelihood of obtaining the approval of a majority of the minority. Often, hiring a financial advisor to perform a valuation or forming an independent special committee is impractical for venture-backed companies with limited funds, time or resources. However, employing some or all of these devices can be impactful.*

Ultimately, deal parties may conclude that the business risks outweigh the benefits. Parties may alternatively conclude that it is better to accept the higher standard but try to get the burden of proof shifted to the plaintiff. With private deals increasingly being scrutinized, a VC-backed company should consult with counsel early-on to assess these risks and consider tactical alternatives. In any case, a board should strive to build the transaction record in a way that demonstrates that it discharged its fiduciary duties in a process that is fair. See A Reminder on Adequate Process (Despite Fair Price): Delaware Court Addresses Breach of Fiduciary Duties in Dilutive Recapitalization Transaction for specific process guidance and considerations.

* In Trados (2013), the court criticized the board's decision not to form a special committee to approve a management incentive plan in connection with a merger that was disproportionately funded by the common stockholders. The transaction was viewed as "interested," which resulted in application of "entire fairness." Although the court ultimately found that the transaction was fair, it noted that had the board used a special committee, it could well have resulted in business judgment review. See ftne. 39.


Judicial developments

Mind the gap (or lack thereof)

Two recent cases in the M&A space regarding earn-outs make one thing clear: express language in the definitive agreement prevails over any implied covenant of good faith and fair dealing.

Fortis Advisors LLC v. Dialog Semiconductor PLC (Del. Ch. January 30, 2015) (granting a buyer's motion to dismiss a claim for breach of the implied covenant of good faith and fair dealing where the merger agreement left no room for implication of additional terms regarding earn-out)

The Court confirmed that, in order to state a claim for breach of the implied covenant of good faith and fair dealing, there must be a gap in the agreement for the implied covenant to operate. "[T]he implied covenant only applies where a contract lacks specific language governing an issue and the obligation the court is asked to imply advances, and does not contradict, the purposes reflected in the express language of the contract." In this action involving a dispute over whether earn-out payments were owed to plaintiff (seller) in connection with a merger transaction, the court did not hesitate to dismiss Plaintiff's claim for breach of the implied covenant, noting that plaintiff "admits it does not believe that any gaps exist in the merger agreement from which to imply an additional contractual term." The merger agreement contained a specific provision addressing earn-out payments, requiring that buyer use its "commercially reasonable best efforts … to achieve and pay the Earn-Out Payments in full," and provided certain detailed obligations and prohibitions (quoted below) concerning the buyer's operation of the business post-close:

… (i) Parent shall, and shall cause its Affiliates … to (A) operate the business of the Surviving Corporation and its Subsidiaries as a separate, stand-alone business unit (understanding that Parent may elect to integrate sales, service, supply chain and administrative functions with those of Parent), (B) maintain a separate research and development organization within such business unit with engineering headcount at a level not materially below that currently maintained by the Company and (C) price the products of the Surviving Corporation on a standalone basis and without any reduction related to the pricing of products by Parent's other product lines and (ii) Parent shall not, and shall not authorize or permit its Affiliates … to, (A) take any action with the intent of avoiding or reducing the payment of any Earn-Out Payment, (B) divert to another business of Parent any business opportunity in a manner that could reasonably be expected to or does diminish or minimize the Earn-Out Payments, (C) take any action for the purpose of shifting Revenue outside of the Earn-Out Periods … or reducing Revenue …

Whether buyer breached said provisions of the merger agreement is not discussed in the opinion, and does not matter for purposes of the holding. The important takeaway is that if the merger agreement speaks directly to the issue in dispute, "implied good faith cannot be used to circumvent the parties' bargain." As the Court held,

"In my opinion, the allegations of the complaint fail to state a claim for breach of the implied covenant because Fortis has not identified, as it must, a gap in the Merger Agreement to be filled by implying terms through the implied covenant. Stated differently, Fortis has failed to identify any implied contract term that it would have this Court read into the Merger Agreement."

Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC (Del. April 23, 2015) (affirming the dismissal of a seller's claim for breach of the implied covenant of good faith and fair dealing and of the earn-out provision of the merger agreement, focusing on the primacy of the agreement's plain language)

This appeal to the Delaware Supreme Court arose from a dispute over earn-out payments following a merger, where the seller argued that the buyer breached both the merger agreement and the implied covenant of good faith and fair dealing by failing to take certain actions that the seller contended would have generated an earn-out payment. As in Fortis above, the court placed great weight on the explicit language of the merger agreement, which specifically "prohibited the buyer from 'tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-Out Payment'" (emphasis added). The Court of Chancery concluded, with respect to the breach of contract claim, that "the merger agreement meant what it said": in order for buyer to have breached Section 5.4 (the earn-out provision), it must have acted with the "intent" to reduce or limit the earn-out payment, and seller had not proven that any business decision of the buyer was motivated thereby. Rejecting the seller's argument on appeal for a knowledge standard (namely, that Section 5.4 precluded any conduct by the buyer that it knew would have the effect of compromising the seller's ability to receive an earn-out), the Delaware Supreme Court held as follows:

"The Court of Chancery acted properly in giving Section 5.4 its plain meaning. By its unambiguous terms, that term only limited the buyer from taking action intended to reduce or limit an earn-out payment. Intent is a well-understood concept that the Court of Chancery properly applied … As Section 5.4 is written, it only barred the buyer from taking action specifically motivated by a desire to avoid the earn-out."

As the Court clarified, the Court of Chancery "never said that avoiding the earn-out had to be the buyer's sole intent, but properly held that the buyer's action had to be motivated at least in part by that intention."

Unsurprisingly, the Court also rejected seller's argument that the buyer violated the implied covenant of good faith and fair dealing. Without reaching "the buyer's well-reasoned argument that Section 5.4 addressed the full range of discretionary conduct relevant to the earn-out calculation, leaving no room for the implied covenant to operate at all," the Court affirmed the Court of Chancery's holding that "the implied covenant did not inhibit the buyer's conduct unless the buyer acted with the intent to deprive the seller of an earn-out payment," which the buyer had not done. The Court went on to note the generosity of the lower court in "assuming that the implied covenant of good faith and fair dealing operated at all as to decisions affecting the earn-out, given the specificity of the merger agreement on that subject," and made clear that "Section 5.4 specifically addressed the requirements for an earn-out payment and left the buyer free to conduct its business post-closing in any way it chose so long as it did not act with the intent to reduce or limit the earn-out payment."


Judicial developments

DE Supreme Court upholds banker liability for inducing faulty process in Rural/Metro sale

On November 30, 2015, in RBC Capital Markets, LLC v. Jervis to confirm the Delaware Supreme Court upheld the principal rulings finding financial advisor RBC Capital Markets, LLC liable for approximately $76 million in damages for aiding and abetting breaches of fiduciary duties by former directors of Rural/Metro Corporation in connection with the company's 2011 sale to private equity fund Warburg Pincus LLC. The Court affirmed the trial court's ruling that the board breached its duty of care under Revlon even though the board's failures were primarily attributable to RBC's undisclosed conflicts of interest. The Court then held that RBC was liable for aiding and abetting the board's breach because it mislead the board and created the informational vacuum that led to the faulty sale process, which proximately caused the company to be sold at a price below fair value.

Factual background

In late 2010, Rural/Metro's board began considering strategic alternatives and assembled a special committee of independent directors. The board hired RBC as its primary financial advisor and Moelis as its secondary financial advisor. At around the same time, Emergency Medical Services ("EMS"), the parent company of a Rural/Metro competitor, had also announced its intention to sell itself. RBC wished to obtain a role providing buy-side financing to any bidder for EMS and believed it could use its position as sell-side advisor to Rural/Metro's board to get on EMS bidders' "financing trees." RBC believed that a buyer of EMS might want to later combine EMS with Rural/Metro and that the buyer would give RBC a role in financing the EMS acquisition in order to gain access to Rural/Metro. With this in mind, RBC structured the Rural/Metro sale to occur on a parallel track with the EMS sale. Meanwhile, RBC also wished to provide acquisition financing to any bidder for Rural/Metro.

Approximately 28 financial bidders were contacted to participate in the Rural/Metro auction. Warburg Pincus submitted the only bid, although another private equity fund (the ultimate buyer of EMS) requested a bid extension but was denied.

On March 28, 2011, after RBC and Moelis delivered their fairness opinions, the board accepted Warburg Pincus' bid for $17.25 per share in cash and the transaction closed in June 2011.

On April 8, 2013, former stockholders of Rural/Metro sued the former board members in the Delaware Court of Chancery on claims for breaches of fiduciary duty, and RBC and Moelis for aiding and abetting those breaches. Within a month, the directors and Moelis settled the litigation in exchange for broad releases of claims for $6.6 million and $5 million, respectively. The case proceeded to trial solely against RBC and on March 7, 2014, Vice Chancellor Laster of the Delaware Court of Chancery issued a post-trial decision holding RBC liable for aiding and abetting the board's breach of its fiduciary duty of care. On October 10, 2014, the Court of Chancery set the amount of RBC's liability at approximately $76 million, constituting 83% of the approximately $91 million in total damages that the stockholder class suffered based on the company's value as a going concern. RBC appealed the decision.

Board's duty of care breach

As a threshold matter, the Delaware Supreme Court found that the enhanced scrutiny standard under Revlon applied when the special committee commenced the Rural/Metro sale in December 2010 because the evidence demonstrated that the committee had decided to sell the company and had already abandoned other strategic alternatives, even though the full board only technically authorized the sale on March 2011. The Court then held that the board failed to fulfill its Revlon duties to attain the best value for the stockholders because it failed to conduct an auction within the bounds of reasonableness. The Court held that, while a board is generally free to rely upon the advice of its financial advisor and to consent to conflicts, the Rural/Metro board failed to implement adequate procedures to actively oversee and manage the sale process, including the need to identify, respond and actively manage RBC's conflicts of interest. The Court concluded that this failure led to a faulty sale process that rendered the pre- and post-signing market checks ineffective and left the board ill-informed of the company's true value.

RBC's aiding and abetting liability

RBC had argued that it could not be found liable for "knowingly participating" in a breach of a fiduciary duty if the underlying breach by the directors is exculpated or not intentional. RBC further argued that it could not "knowingly participate" in the breach if its conduct was simply to mislead the board. The Court disagreed, holding that it is the aider and abettor, not the board, that must act with scienter for purposes of aiding and abetting liability. It then affirmed the trial court's ruling that "[i]f the third party knows that the board is breaching its duty of care and participates in the breach by misleading the board or creating the informational vacuum, then the third party can be liable for aiding and abetting."

Importantly, the Court noted that its ruling was narrow and should be cabined by the "unique facts" at hand. In response to an amicus brief that argued for a reversal due to the "anomalous imbalance of responsibilities" that would occur if a banker is held liable for aiding and abetting a duty of care breach for which the board, itself, is exculpated — the Court urged parties not to read the decision expansively. The Court noted that the decision was tightly premised on the financial advisor's intentional "fraud on the board" and explained that the decision should not be read to subject a financial advisor or non-fiduciary to aiding and abetting liability for its failure to prevent a duty of care breach. It then dispelled the notion of "gatekeeper liability" for advisors and said that the decision should not be read to support the Court of Chancery's dictum characterizing financial advisors as "gatekeepers" for boards generally in an M&A transaction.

Corwin v. KKK Financial Holdings

The Court also addressed what standard of review should apply to the underlying duty of care breach for purposes of a third-party's aiding and abetting liability. In Corwin v. KKR Financial Holdings LLC (Del. October 2, 2015), the Court held that the business judgment rule (not Revlon) applied in post-closing claims against directors for monetary damages where the transaction was negotiated at arms-length and the stockholders had approved the transaction in an informed vote. RBC argued that under KKR Financial, the trial court had erred by finding a duty of care violation without finding that the board acted with gross negligence. The Court disagreed, finding that its application of Revlon was a sufficient predicate for its finding of aiding and abetting liability against RBC. The Court acknowledged KKR Financial but noted that the plaintiffs here were not seeking to impose liability on the director defendants and that for purposes of aiding and abetting liability, a duty of care breach had occurred. (While not discussed, the posture here was also different in that the stockholders' vote was not informed.)


The RBC decision concludes the latest chapter in Delaware's long-standing focus on banker conflicts that were initially highlighted in Del Monte and El Paso but also recently discussed in In re PLX and In re Zale Corporation. The ruling serves as another reminder that while boards are free to accept and waive financial advisor conflicts, it is ultimately the board's responsibility to be active and diligent throughout the sale process, which includes the need to identify, manage, oversee and disclose those conflicts. While none of this is new, the more recent decisions strongly suggest the need for boards to thoroughly diligence (through contracts or otherwise) any actual or potential conflicts of interest and to disclose material conflicts to stockholders in as specific detail as possible. While many parties have already adopted these deal practices, for boards, RBC and the more-recent decisions should help combat bankers' reticence to disclose and vet potential conflicts at the outset of (or even better, before) an engagement and to address such conflicts specifically in representations and covenants in the banker engagement letter and throughout the sale process. It is worth emphasizing, however, that a board decision to proceed with an engagement that is the product of best practices in spite of any real or perceived conflict should not impact the legitimacy of the engagement.

See RBC Capital Markets, LLC v. Jervis (Del. Nov. 30, 2015).

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