In December 2002 the Delaware Supreme Court surprised most US mergers and acquisitions lawyers by invalidating a merger agreement between NCS and Genesis Health Ventures. The reason, it said, was that the agreement, together with a stockholder voting commitment, made it inevitable that the merger would take place, even if a better offer were received after the agreement was signed. However, the decision, in Omnicare v NCS Healthcare, had been reached on an expedited basis, and the opinion explaining the reasons for the decision was not issued until early April.
When the opinion was issued, it confirmed that the Delaware Supreme Court had indeed changed what most M&A lawyers thought was the applicable law. It said the NCS board of directors had breached its fiduciary obligations by approving a merger agreement that the board could not cancel if it received a better offer and that was sure to receive the required stockholder approval, even though the buyer repeatedly said it would not enter into a transaction on any other basis.
The proposed merger
The case involved the culmination of two years of efforts to find a buyer for the company by the board of NCS, a publicly traded company engaged primarily in providing pharmacy services to long term care facilities.
NCS had two classes of stock: Class A stock that entitled holders to one vote a share and Class B stock that entitled holders to 10 votes a share. Two officer/directors, Jon Outcalt and Kevin Shaw, owned Class B stock that entitled them to approximately 65% of the vote even though it was less than 20% of the outstanding stock. NCS also had two other directors, both of whom were sophisticated and totally independent.
NCS was in financial difficulty. By the end of 1999, it was in default on $206 million of senior bank debt and $102 million of publicly held subordinated notes. Its board decided that the only way out for NCS was to find an acquirer or an equity investor, and in February 2000 NCS hired UBS Warburg to help with the sale. UBS Warburg contacted more than 50 potential acquirers, but received only one non-binding indication of interest relating to a purchase of all NCS's assets for $190 million, which was reduced after due diligence by 20%. Even the original proposal was less than the amount of NCS's senior bank debt and would have provided nothing for the holders of NCS's subordinated notes or its shareholders.
By the spring of 2001, the company's subordinated notes had been declared in default and the noteholders had formed an ad hoc committee to deal with NCS. In July, the ad hoc committee asked Omnicare, which is in the institutional pharmacy business, to make a proposal. Omnicare proposed first a $225 million and then a $270 million purchase of NCS's assets in a bankruptcy sale, in each case subject to satisfactory completion of due diligence. The NCS board was unwilling to accept either Omnicare proposal, because it did not want to put NCS through a bankruptcy proceeding, and it thought the price was too low.
Omnicare then began secret discussions with the ad hoc committee. In February 2002, the committee told the NCS board that Omnicare was willing to pay $313.75 million in a bankruptcy sale.
Meanwhile, in January 2002, the committee introduced NCS to Genesis, a company engaged in providing health care services to the elderly. Genesis had previously lost an acquisition of another company to a last minute bid by Omnicare, and was bitter about its experience. Therefore, although Genesis was interested in discussing a purchase of NCS, Genesis made it clear that it would not negotiate as a stalking horse and by doing so simply identify the amount Omnicare would have to exceed "to maintain its competitive monopolistic position".
In June 2002, Genesis proposed a transaction that would not involve a bankruptcy, would provide substantial (but not full) recovery for NCS's subordinated noteholders, and would provide the possibility that the NCS stockholders would receive something. By late June, Genesis was proposing a transaction under which the subordinated noteholders and trade creditors would be paid in full (not including accrued interest) in a combination of cash and Genesis stock and the NCS stockholders would receive $20 million in value. Subsequently, at the request of the independent directors, Genesis increased what stockholders would receive to $24 million, but said it would not conduct any further negotiations until NCS entered into an exclusive negotiation agreement with it, which NCS did.
By late July 2002, Omnicare came to believe NCS was negotiating a transaction with Genesis or another of Omnicare's competitors. It sent a letter to the NCS board proposing a transaction in which Omnicare would retire NCS's senior and subordinated debt at par plus accrued interest and would pay the NCS stockholders $3 per share in cash (a total of almost $75 million).
However, that proposal was expressly conditioned on, among other things, completion of due diligence. Omnicare rejected requests that it eliminate the due diligence condition.
NCS was precluded by its exclusive negotiation agreement with Genesis from discussing the Omnicare proposal with Omnicare. However, NCS's independent directors used Omnicare's letter to request improved terms from Genesis. In response, Genesis substantially improved the terms it was proposing, so that all NCS's debt would be paid in full, including accrued interest and a small redemption premium with regard to the subordinated notes, and what was to be paid for the NCS stock would be increased by 80%.
However, in return for these and other concessions, Genesis insisted that the NCS board approve the transaction by midnight on the next day, or Genesis would terminate discussions and withdraw its offer. Genesis also insisted that Outcalt and Shaw (whose vote, by itself, would constitute the necessary stockholder approval) enter into a binding agreement to vote for the transaction. Finally, Genesis insisted that the merger agreement provide, as was specifically permitted by a recent amendment to the Delaware corporate statute, that even if the board withdrew its recommendation, the transaction would be submitted for a vote of the NCS stockholders (which the Outcalt and Shaw voting commitments ensured would be favourable).
The independent directors of NCS, distrustful of the Omnicare proposal with its due diligence condition, recommended that the board approve the Genesis transaction. The board concluded that: "Balancing the potential loss of the Genesis deal against the uncertainty of Omnicare's letter, results in the conclusion that the only reasonable alternative for the board of directors is to approve the Genesis transaction." Accordingly, the board approved the Genesis merger and Outcalt and Shaw contractually committed themselves to vote in favour of the deal.
Within a few days after the Genesis merger agreement was signed, both a group of NCS stockholders and Omnicare filed lawsuits seeking to invalidate the merger agreement. Seven days later, Omnicare began a tender offer for all NCS's shares at the price of $3.50 per share and sought to discuss its offer with the NCS board. However, Omnicare's proposal was conditioned on completion of a due diligence investigation of NCS. It was not until two months later that Omnicare irrevocably committed itself to a transaction. Shortly after that happened, the NCS board withdrew its recommendation that stockholders vote in favour of the Genesis merger and NCS's financial adviser withdrew its opinion that the Genesis transaction was fair to the NCS stockholders. However, the NCS board pointed out that, notwithstanding the withdrawal of its recommendation, the Outcalt and Shaw voting agreements ensured stockholder approval of the Genesis transaction.
Rulings
The Delaware Chancery Court, which hears most litigation regarding Delaware corporations, held that the board's action should be reviewed on the basis of the business judgment rule, which precludes courts from substituting their judgment for that of the board if the board's decision could be "attributed to any rational business purpose". The Chancery Court went on to say, however, that even if the transaction were subject to an enhanced judicial examination of whether the directors' action was within the range of reasonableness, the directors' decision was appropriate.
By a three-to-two vote, the Delaware Supreme Court disagreed. It analyzed the situation under a rule developed in cases involving hostile takeovers that says the steps a board takes to protect against a takeover must be reasonable in light of the threat posed by the takeover. The Delaware Supreme Court treated the steps taken to ensure that the Genesis transaction would take place as protection against a higher bidder and said the protection must be reasonable in light of the threat that Genesis would withdraw its offer.
The Delaware Supreme Court recognized that there is a range of what is reasonable for a board. However, it said that a board may not adopt defensive responses that are draconian (that is, preclusive or coercive), and that a court must first determine that responses are not draconian, before it reaches the question whether they are within a range of reasonableness. It ruled that, because the NCS board knew the stockholder approval was a forgone conclusion, its approving an agreement that did not give the board an option to terminate the agreement if a higher bid were received (a so-called fiduciary out) was both coercive and preclusive. It coerced the stockholders into going along with the merger and it precluded consideration of any superior transactions. Therefore it was not within a reasonable range of responses to the perceived threat of losing the Genesis offer. Accordingly, the Delaware Supreme Court ruled that the merger should be enjoined.
As noted, the justices of the Delaware Supreme Court split three-to-two over the Omnicare decision. Split decisions by the Delaware Supreme Court, especially in the field of corporation law, are rare. Further, the dissenting opinions were extremely strongly worded. One of the dissenters noted that by requiring that there must always be a fiduciary out, the universe of potential bidders who could reasonably be expected to benefit stockholders could shrink or disappear. He expressed a hope that the decision would be viewed as limited to the peculiar facts of the Omnicare case, and that if so, "negotiators may be able to navigate around this new hazard". The other dissenter said he "would not shame the NCS board, which acted in accordance with every fine instinct which we wish to encourage".
Analysis
Decisions of the Delaware courts on corporate law matters are extremely important in the US. Most publicly owned companies are incorporated in Delaware, and therefore are directly affected by Delaware corporate law. Further, courts in other states frequently follow corporate law decisions of the Delaware courts.
At least until the Omnicare decision, most US M&A lawyers believed a board had the power to approve a contract that did not include a fiduciary out if the board felt it was in the best interests of the corporation and its stockholders to do so. If a purchaser offered $20 per share under an agreement that contained a fiduciary out or $24 per share under an agreement that did not contain one, most lawyers would have said the board could exercise its judgment whether to give up the possibility of accepting a higher offer if one were received in exchange for locking in the additional $4 per share. Omnicare creates doubt about that.
It is easy to understand why buyers want to be sure that when they bind themselves to undertake a transaction, the transaction will take place. Once a buyer agrees to a transaction, the buyer often has to arrange financing, has to begin integration planning and has to hire people who will help manage the company it expects to acquire. Some of the buyer's employees may leave in anticipation of becoming redundant because of the acquisition, and, if the buyer is publicly owned, the buyer's stock may move sharply in reaction to announcement of the transaction. Many potential buyers don't want to confront these things unless they are sure the transactions will take place. A fiduciary out takes away this certainty.
It is not clear whether the Omnicare decision requires that every agreement to sell a Delaware corporation (or at least a publicly held Delaware corporation) include a fiduciary out. It is possible that, absent stockholder agreements ensuring approval of a transaction, a board can bind a corporation to submit a transaction to its stockholders and leave it to the stockholders to reject the transaction if a more attractive one surfaces. However, even if that is the case, it is not clear what level of assurance of stockholder approval makes it mandatory that an agreement have a fiduciary out. Is a fiduciary out required only if holders of a majority of the votes are bound to vote for the transaction, or would a voting agreement by holders of 49%, or 40% or 35% of the voting power require the board to insist on a fiduciary out?
If the reason the NCS board was required to insist on a fiduciary out was that holders of a majority of the stockholder votes had agreed to vote for the transaction, then the reason the board's approving the Genesis transaction breached its fiduciary obligations was because it was in accordance with the strong desires of holders of a majority of the stockholder votes. That is strange, particularly when the interests of the holders of a majority of the vote were no different from those of the other stockholders (that is, to obtain the highest price for their shares).
The Delaware Supreme Court noted that it is suspect when a board acts to prevent stockholders from effectively exercising their right to vote contrary to the will of the board. If the NCS board had refused to give Genesis the deal protection it insisted upon and Genesis had walked away, the NCS board would have thwarted the strong desires of the holders of a majority of the stockholder vote. It is interesting to speculate what the NCS litigation would have looked like in that case (particularly if, as the NCS board apparently feared would occur, after Genesis dropped out of the situation, Omnicare either didn't submit a firm offer or submitted a firm offer at a price far below what Genesis had been offering).
Perhaps the majority decision in Omnicare was influenced by the fact that the stockholders who held a majority of the voting power did not hold a majority of the outstanding shares. However, Delaware law expressly authorizes different classes of stock to have different voting rights, and as one of the dissenting justices noted, the shareholders knew when they bought their shares that the multiple voting shares carried with them a majority of the voting power. Further, there is nothing in the Omnicare decision that says it is limited to situations in which a majority of the votes could be committed by holders of less than a majority of the shares.
If the controlling NCS shares could have been transferred without losing their majority voting power (which was not the case with regard to NCS, but is the case with regard to most corporations that have majority shareholders), Genesis might have tried to ensure completion of the acquisition by purchasing those shares and then entering into the merger agreement. If Genesis had done that even if the merger agreement had contained a fiduciary out, nobody else could have taken NCS away from Genesis, because Genesis' vote would have been necessary to approve a sale to anybody else. However, the logic of the Omnicare decision probably would have required the NCS board to prevent Genesis from acquiring the majority voting interest.
Under Delaware law, a person who acquires more than 15% of a company's stock without prior board approval is precluded from entering into a merger or similar transaction with the company for three years unless the acquisition is of more than 85% of the company or the subsequent transaction is approved by two-thirds of the unrelated shareholders. Therefore, if Genesis had acquired the majority voting interest without prior approval of the NCS board, it might not have been able to complete its acquisition of NCS for three years. Accordingly, Genesis almost surely would have insisted on approval by the NCS board before it would acquire the majority voting interest. But the reasoning that led to the Omnicare decision would seem to preclude the NCS board from giving that approval and, by doing so, enabling Genesis to veto any alternate transaction that might come along.
At least until Omnicare, it was common for a board to refuse to approve an acquisition of a majority, or near majority, interest unless the purchaser agreed to offer to purchase the remaining stock for the same price. Now, approval of the acquisition of a majority shareholding may be unlawful because it assures that the purchaser will be able to acquire the remaining stock for the same price.
Omnicare's legacy
How great an effect will the Omnicare decision have on purchases of Delaware corporations? We may never know.
For many years, fiduciary outs have been common in agreements for the sale of Delaware corporations (and corporations incorporated in other states of the US). Normally, only a purchaser who is willing to pay a substantial premium for a company has been able to negotiate an agreement that precludes higher bidders. Further, it makes little difference whether an agreement contains a fiduciary out if shareholders can vote down the transaction if a better offer comes along. Yet neither the frequent existence of fiduciary outs nor the ability of shareholders to vote down transactions has prevented transactions from taking place.
The principal effect of preventing locked in transactions may be on the prices stockholders receive. The fact that somebody who signs a purchase agreement may subsequently be outbid tempts buyers not to put their highest price on the table if there is any possibility of a subsequent bidder. Doing so makes it too easy for a potential competing bidder to know exactly what it will have to bid to acquire a company. If a competing bidder in fact appears, the amount the buyer holds in reserve may eventually be added to the purchase price. But if there is no competing bidder, the extra amount the buyer would have paid if it could have been protected against subsequent bids will be lost.
The Omnicare decision may even endanger the effectiveness of auctions as a way of eliciting the highest possible price. An auction only works if there is a clear end to the bidding and it is certain that whoever is the high bidder at that time will win. In order to ensure finality of an auction of a company, it is common to require anybody who wants to participate in the auction to agree not to bid for the company other than through the auction.
Omnicare casts doubt on the enforceability of a provision of that type. If a board cannot enter into an agreement with a purchaser that precludes the board from entertaining superior proposals, how can it preclude the companies that are most likely to make the superior proposals from doing so? And if a board tries to preclude everybody who participates in an auction from bidding after the auction is over, why should a potential purchaser participate in the auction when it can wait until the auction is over and then decide whether to top the winning bid?
The Delaware courts have long claimed they will not substitute their judgment for the judgment of well-informed directors who do not have personal conflicts of interest. And most of the time they have adhered to that. They have imposed on directors a duty of loyalty (to act in good faith in what they deem to be the best interests of the corporation and its stockholders) and a duty of care (to use reasonable efforts to be fully informed). If those duties are met, the Delaware courts have normally deferred to the decisions of the directors. In Omnicare, there was no claim that the NCS directors breached either their duty of loyalty or their duty of care. Rather, the Delaware Supreme Court seems to have developed an absolute standard that precluded directors from exercising their unbiased judgment as to what was best for the stockholders.
Undoubtedly, if subsequent decisions limit the Omnicare holding to the issues the court actually decided, even if that essentially prevents agreements that lock up acquisition transactions, lawyers will navigate around that problem. The more serious problem is that Omnicare appears to undercut the basic concept that Delaware courts will not substitute their judgment for that of an informed, disinterested board. If that is what it does, it has done substantial damage to one of the reasons people from all over the US incorporate corporations in Delaware. Unfortunately, it may be a long time before subsequent decisions tell US lawyers what the Omnicare decision truly means.