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One of the primary objectives of a lawyer representing the acquirer in an acquisition of a public company is to structure the transaction in a way that enhances the probability that the deal will actually be consummated. The acquirer will devote significant internal and external resources to investigating a potential target and negotiating a transaction. The last thing it wants is to see a third-party interloper, often a competitor, spring out of the shadows and acquire the target company while the deal is still pending. The interloper threat is highest prior to the shareholder vote, which usually takes place about three months after the deal for a public company is announced while the merger proxy process runs its course. Lockup arrangements, whereby a target company is restricted in its ability to enter into alternative transactions, can reduce the interloper risk. But under Delaware corporate law (and that of most other states), there is an incessant tension between when these protective lockups are valid and when they might result in a breach of a board’s fiduciary duties. Although a target company may announce a transaction and agree not to seek better offers, its board continues to be obligated to consider better proposals if any surface. Hence, a target board cannot enter into a binding merger agreement that effectively precludes superior offers without breaching its fiduciary duties. In this regard, interesting developments in Delaware case law based on decisions in Omnicare Inc. v. NCS Healthcare Inc. (Del. 2003) and Orman v. Cullman (Del. Ch. 2004) provide important guidance. HOW TO LOCK UP Lockups are used in public company deals, often consisting of a combination of the following: • Termination fees. The target agrees to make a cash payment to the acquirer if the target terminates the deal or changes its recommendation to its shareholders. The payment makes it costly for the target to change its mind and also serves to compensate the acquirer for its time, expenses, and opportunity cost. • No-shop provisions. The target promises to deal only with the acquirer and not solicit other proposals. These provisions usually allow the target board to consider unsolicited proposals by third parties under certain circumstances and within specified parameters. • Voting agreements. A shareholder (usually a large shareholder) agrees to vote in favor of a transaction and against alternative transactions, thereby making it difficult for a third party to win approval for an alternative transaction. • Stock options. The acquirer is given the option to purchase a block of the target’s common stock at a specified price (usually the deal price) if the deal is terminated and a third party has agreed to acquire the target. Alternatively, a large shareholder gives the acquirer an option to acquire its shares if the deal is terminated. In most mergers, unless a sizable shareholder of the target company exists, the lockup consists of the no-shop provision with termination fees and a carefully crafted “fiduciary out.” Under state law, directors have a fiduciary duty to act in good faith, make informed decisions, and act in a manner they reasonably believe to be in the best interest of the company and its shareholders. In the mergers and acquisitions context, the duty of the target’s directors extends to securing the best transaction for the shareholders. Thus, there exists a tension when a board causes a company to enter into a binding agreement that may hinder the consideration of alternative proposals by third parties. To address this issue, merger agreements typically contain “fiduciary out” provisions, which allow the target’s board to terminate the deal or change its recommendation if its fiduciary duties require it to do so, such as when a third party proposes what the board believes to be a superior transaction. In determining whether to opt for an alternative transaction, the directors must have a good-faith belief that the alternative transaction is superior from a financial point of view. The company will usually hire a financial adviser to help in this determination. OMNICARE V. NCS Two recent Delaware cases address when lockup agreements are invalid and when they are enforceable. These cases � one where the court struck down the lockup and the other where the court upheld it � are described in some detail below as they shed important light on the parameters of what is acceptable and not acceptable under Delaware law. In the summer of 2001, NCS Healthcare Inc., which was in financial distress, and Omnicare Inc. began discussions. Over the next few months, Omnicare made two offers to acquire NCS’s assets under the Bankruptcy Code. Both of these offers were less than the face value of NCS’s debt, and neither provided any recovery for NCS stockholders. In January 2002, NCS began discussions with Genesis Health Ventures Inc. In June 2002, Genesis offered a price that would allow for repayment of NCS’s debt (at par value), as well as some recovery for NCS’s stockholders, and NCS executed an agreement. By late July, Omnicare came to believe that NCS was negotiating a transaction with another entity � possibly Genesis or one of its other competitors. On July 26, Omnicare faxed to NCS a letter containing an “offer to negotiate” a transaction. After reviewing this offer to negotiate, the NCS board � fearful of losing the Genesis bid and concerned that if Genesis walked away they would be stuck with a bankruptcy deal with Omnicare � went back to Genesis, which sweetened its offer in response. In return, Genesis demanded that NCS agree to a fully locked-up deal, or else it would walk away. After careful deliberation, NCS accepted the Genesis proposal. The lockup consisted of (1) voting agreements by the two largest NCS stockholders to vote for the merger and (2) a provision in the merger agreement (with no fiduciary-out) that required the merger to be placed before stockholders for a vote even if the NCS board no longer recommended it. Together, these provisions guaranteed that the Genesis merger would be approved. Omnicare and a shareholder class brought suit, and the Delaware Supreme Court invalidated the lockup for two reasons: (1) The board’s decision to approve the lockup failed to satisfy the so-called Unocal/Unitrin proportionality analysis, and (2) the lockup prevented the NCS directors from exercising their continuing fiduciary duties to protect minority stockholders. First, the majority clarified that adoption of deal-protection devices warrants enhanced scrutiny (rather than a review deferential to the board’s business judgment) under all circumstances. The court described the appropriate standard: “[I]n applying enhanced judicial scrutiny to defensive devices designed to protect a merger agreement, a court must first determine that those measures are not preclusive or coercive before its focus shifts to the ‘range of reasonableness’ in making a proportionality determination.” The court concluded that “[t]he deal protection devices adopted by the NCS Board were designed to coerce the consummation of the Genesis merger and preclude the consideration of any superior transaction.” The court’s analysis was focused squarely on the effect of the lockup on the minority stockholders. As the court explained, “Although the minority stockholders were not forced to vote for the Genesis merger, they were required to accept it because it was a fait accompli.“ Next, the court explained that the lockup was invalid because it prevented the NCS board from continuing to exercise its fiduciary duties to NCS stockholders. Specifically, the court explained that “the NCS board did not have the authority to accede to the Genesis demand for an absolute lock-up.” After Omnicare, it appears that an irrevocable lockup (i.e., a merger agreement with no effective out) is not permitted under Delaware law. ORMAN V. CULLMAN The outcome in a more recent case was different. General Cigar, a tobacco company, was founded by the Cullman family, which owned a substantial amount, although not a majority, of the company’s Class A stock. The family retained voting control due to their ownership of the company’s Class B stock, which was entitled to 10 votes per share. In 1999, another tobacco company, Swedish Match, proposed to acquire a significant stake in General Cigar. As a condition to entering into the deal, Swedish Match required the Cullmans to vote in favor of the merger. If the deal fell apart, the Cullmans were also required to vote against any other transaction proposals for the next 18 months. There was also a “force the vote” provision requiring the proposal to be placed before stockholders even if General Cigar’s board no longer recommended it. Unlike the Omnicare deal , however, this transaction was subject to approval by a “majority of the minority.” The Cullmans agreed to vote their shares of Class A common stock pro rata in accordance with the vote of the Class A public shareholders, who were a “minority” in terms of voting power. This effectively gave the public shareholders veto power over the proposed transaction. A shareholder suit was brought alleging breach of fiduciary duties based on the precedent in Omnicare, but the Delaware Chancery Court distinguished this case from Omnicare. The court explained that “unlike the situation in Omnicare, the deal protection mechanisms at issue in this case were not tantamount to ‘a fait accompli.’ The public shareholders were free to reject the proposed deal. . . . Because General Cigar’s public shareholders retained the power to reject the proposed transaction with Swedish Match, the fiduciary out negotiated by General Cigar’s board was a meaningful and effective one.” STRUCTURING LOCKUPS TODAY The Omnicare and Orman decisions answer some questions. It is now clear that lockups, in the aggregate, cannot be “coercive and preclusive.” This is required even under unique business circumstances, like the NCS situation where the company was severely distressed. But the cases raise other issues. For example, can a majority shareholder execute a written consent approving a deal and hence eliminate the interloper risk period prior to any shareholder vote? Also, Orman, which serves to clarify Omnicare, provides that merger agreements must include fiduciary outs that are “meaningful and effective.” Thus, the door must be left open to better offers, but just how far remains to be tested in future cases. Lockups are always among the most heavily negotiated provisions in a merger agreement as lawyers wrestle to strike a proper balance between the acquirer’s desire for certainty and the target’s requirement for flexibility. Omnicare and Orman, while instructive, will not change that. Pankaj Sinha is a partner in the D.C. office of Skadden, Arps, Slate, Meagher & Flom, where he specializes in corporate transactions. He may be reached at [email protected].

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