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A controversial Delaware Supreme Court decision knocks down a tactic for sealing a merger agreement.
Edward Teach, CFO Magazine
November 1, 2003
If there's anything a dealmaker hates, it's uncertainty. But thanks to the controversial Delaware Supreme Court decision in Omnicare Inc. v. NCS HealthCare Inc., more uncertainty in mergers and acquisitions may lie ahead.
In a rare 3-2 split decision last April, Delaware's highest court invalidated a merger agreement between NCS and Genesis Health Ventures that was protected by a shareholder lockup, a commonly used technique for ensuring that a deal will be consummated. Calling the lockup and other deal-protection devices "coercive" and "preclusive," the court reversed a Delaware Court of Chancery decision that tolerated the lockup—through which Genesis had essentially frozen out Omnicare's superior offer for NCS.
Not all lockups are designed expressly to seal a negotiated deal. Stock-option lockups, asset lockups, and breakup fees are types of lockups that let suitors claim a consolation prize if their offers are trumped between the signing of a merger agreement and the shareholder vote. In a shareholder lockup, by contrast, an acquirer secures the backing of large or controlling shareholders prior to the actual vote, an approach naturally more common in the pursuit of smaller companies.
The decision in Omnicare doesn't put an end to shareholder lockups, but it does undercut the effectiveness of the tactic. "Those of us who practice in the area don't believe, and didn't before this case, that in normal circumstances you could lock up a deal all the way," says Frederick S. Green, senior partner and head of the M&A practice at Weil, Gotshal & Manges LLP in New York. "But if there was ever a fact pattern where you might get yourself comfortable that you could do it, it was this one."
Genesis of the Case
The story behind Omnicare begins in late 1999, when NCS, a Beachwood, Ohio-based provider of pharmacy services to long-term-care institutions, began to suffer from a decline in government and third-party reimbursements. In February 2000, it hired a financial adviser to help find an acquirer or equity investor, but an exhaustive search turned up only one offer, which required filing for bankruptcy and arranging a so-called Section 363 bankruptcy asset sale, for an amount well below its debt.
Unhappy with that option, NCS changed advisers in December 2000 and continued its search for a financial savior. By early 2001, the company was in default on some $350 million in debt. Then, in the summer of that year, NCS began talks with another potential suitor—Omnicare, an 800-pound gorilla in the institutional-pharmacy business, with 2002 sales of $2.6 billion. But Covington, Kentucky-based Omnicare also proposed a 363 sale, conditioned on due diligence, that would pay down more of the debt but, again, leave nothing for shareholders.
As 2002 dawned, NCS's business began to revive, giving its board renewed hope that a better offer could be found. In January, a committee of NCS creditors began discussions with Genesis, a Kennett Square, Pennsylvania, provider of health-care services for the elderly. Genesis signed a confidentiality agreement with NCS and began due diligence.
The NCS board wanted to find a "stalking-horse" bidder, one that would establish a baseline valuation for the company. But Genesis had no interest in that role. It saw a good fit in NCS—and a potential rival in Omnicare, which had previously outbid Genesis for another company.
In June 2002, Genesis privately made an offer to merge with NCS, paying off the NCS debt and giving shareholders $24 million worth of Genesis stock. But there was a catch: Genesis wanted a lockup. Specifically, it demanded voting agreements that would irrevocably commit the Class B shares (with 10 votes per share) of NCS chairman Jon H. Outcalt and president and CEO Kevin B. Shaw in favor of the deal. Together, the two owned a minority of total shares outstanding, but more than 65 percent of the voting power of the company's stock.
Genesis also insisted on inserting a "force-the-vote" provision in the merger agreement, under Section 251(c) of Delaware General Corporation Law, enabling the merger proposal to be put to a shareholder vote even if the NCS board didn't endorse the merger. Finally, Genesis required that the merger agreement omit an effective "fiduciary out," a clause that would have allowed the board to terminate the deal if another bidder made a superior offer.
As Genesis and NCS were completing the merger terms, Omnicare began to suspect that some deal for NCS's equity was being negotiated. In late July, Omnicare suddenly proposed a debt-plus-stock acquisition, conditioned on due diligence. NCS then took that proposal to Genesis, which privately responded on July 27 by upping its offer and demanding acceptance by midnight the next day.
On July 28, the NCS board accepted the Genesis offer, executing the shareholder lockup and other provisions. Four days later, Omnicare filed suit in the Delaware Court of Chancery to stop the NCS-Genesis merger. At the same time, it announced it would launch a tender offer for NCS's shares, at $3.50 a share—more than twice the value of the Genesis deal. On October 6, Omnicare made an irrevocable cash offer of $3.50 for all outstanding NCS shares, and the four-person NCS board (which included Outcalt and Shaw, the two majority shareholders) withdrew its recommendation of the Genesis offer.
But since Genesis had obtained the voting agreements, the force-the-vote clause, and the omission of a fiduciary out, the board's action was moot.
Or so it seemed.
In November 2002, the Court of Chancery ruled in favor of NCS. Regarding the board's decision to merge with Genesis, the lower court deferred to the business-judgment rule—the presumption that the NCS directors acted in good faith, on an informed basis, for the best interests of the company. Regarding the board's acceptance of the deal-protection devices, the court concluded that doing so was a "reasonable and proportionate" response to the threat of losing the deal.
Three members of the Delaware Supreme Court thought otherwise. They ruled for Omnicare on appeal and stopped the NCS-Genesis merger in December 2002. The following April, the court explained why.
"In the absence of an effective fiduciary out clause, those defensive measures are both preclusive and coercive," wrote Justice Randy J. Holland, holding for the majority that the lockup was invalid and unenforceable. The deal-protection devices were "designed to coerce the consummation of the Genesis merger and preclude the consideration of any superior transaction." And the NCS board "was required to negotiate a fiduciary out clause to protect the NCS stockholders if the Genesis transaction became an inferior offer," the judge wrote. The board, in short, could not disable itself from performing its fiduciary duty of weighing competing offers for the company.
In his lengthy dissent, Delaware Chief Justice E. Norman Veasey emphasized the context of the deal. "The essential fact that must always be remembered is that this [merger] agreement and the voting commitments of Outcalt and Shaw concluded a lengthy search and intense negotiation process in the context of insolvency and creditor pressure where no other viable bid had emerged," he stated. Veasey was joined in his dissent by Justice Myron T. Steele, who also wrote a separate dissent.
The decision surprised legal experts, to put it mildly. "If you had taken a poll of M&A practitioners—or academics for that matter—90 percent would have said the case would have come out the other way," comments Harvard Law School professor John C. Coates. "In particular, they would have said that [shareholders were] entitled as a matter of law to commit themselves to support a particular deal, without regard to whether or not that particular buyer was going to be offering the highest amount of money for the overall company."
It is easy to get entangled in the catch-22 logic of Omnicare. And no doubt legal scholars will debate the decision for a long time. But at least one observer doesn't mince words when asked if the case is good law or not.
"I think the opinion is a travesty," declares George V. Hager Jr., executive vice president and CFO of Genesis, who played a leading role in negotiating the merger agreement and lockup. "We felt that the facts and the law were very much on our side." The Supreme Court's opinion, he says, boiled down to "the Delaware justices second-guessing the business and fiduciary judgment of the NCS board of directors."
What if an opinion similar to Omnicare had already been on the books when the NCS creditors approached Genesis seeking a deal? "We would never have pursued the transaction," says Hager. "And therefore, the shareholders of NCS would have received nothing. And there would have been a discounted recovery to the lenders and the debt investors."
Although Genesis was not a defendant, it was the true loser in this case. Omnicare bought NCS in January 2003, for $5.50 a share, and the NCS shareholders received a much higher price for their stock. Genesis, the first company that actually offered something for NCS's shareholders, got a termination fee for its efforts.
Include an Out
In his dissent, Veasey expressed hope that the effects of the Omnicare ruling would be confined to that case, allowing future negotiators "to navigate around this hazard." (The ruling, it should be noted, doesn't affect deals involving companies incorporated in other states, although other states do look to Delaware for precedents.) And to some, the unusual circumstance of a divided court suggests some legal uncertainty. "We have so little experience with split decisions in Delaware," says Coates. "We don't really know how [the courts will] view this decision in the future."
For now, dealmakers should avoid merger agreements that lock up a majority of shareholders with no fiduciary out. It may still be permissible, albeit risky, to lock up a minority of shareholders with no fiduciary out, but it remains to be seen when a minority becomes large enough to run afoul of the Omnicare precedent.
"Ten to 15 percent of people never show up at the shareholder meeting," notes Mark H. Burnett, co-chair of the M&A group at Testa, Hurwitz & Thibeault LLP in Boston. "Is the highest number then not 50 percent but 45 percent, or 40?" Nevertheless, Burnett would advise a buyer so inclined to "be aggressive and try to get lockups for as many shares as possible below a majority."
Without the higher degree of certainty that a deal will be consummated that bidders once had, meanwhile, they may balk at putting their best offer—or any offer—on the table. "You're going to be much more worried now, as a buyer, that somebody else will come in and try to top your bid and take advantage of all the work you've done in figuring out this is a good deal from the beginning," says Coates. The effect could be lower prices for sellers, although Coates, for one, expects only "a slight downward effect on mergers and acquisitions" because of the precedent.
Green of Weil Gotshal points out that Omnicare "doesn't invalidate the use of any one lockup mechanism." But it does raise the specter of the court blocking a deal "if you've disenfranchised the stockholders by board action," he adds.
Indeed, the emphasis on the rights of minority shareholders may be the most influential effect of the case. The Delaware high court "essentially wants to give shareholders, as a group, the ability to make a choice," says Burnett. And when two offers are on the table, that usually means taking the better one.
Edward Teach is articles editor of CFO.