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American Bar Association

ABA Section of Business Law

ABA Section of Business Law
Business Law Today
January/February 1999

Protecting the deal in an auction

Contract rights vs. corporate control


Varallo is a director of Richards, Layton & Finger, P.A. of Wilmington, Del. Howard is a director in the Palo Alto Calif. office of Gray Cary Ware & Freidenrich. One or both of the authors and their firms served as counsel in several of the cases discussed in this article, and the views expressed are solely those of the authors, and not the views of their firms or their clients. The authors wish to thank Leanne J. Reese of the Delaware bar for her assistance in preparing this article.

Bidding contests for control of public companies appear to have grown both in frequency and intensity over the past year. Fiduciary law principles in the context of an "auction" for control, the development of which appeared to stagnate in the early part of this decade, once again are being developed in the courts.

Unlike the earlier case law development of so-called "auction" principles, which appeared to focus on fiduciary principles to the virtual exclusion of contract rights, however, recent case law appears to attempt to strike a more rational balance between fiduciary obligations and contract rights. As the courts attempt to balance contract rights and fiduciary duties in the context of auctions, they are actually balancing the rights of shareholders to receive the best available price with the contract rights of a bidder. The authors believe that recent attempts to more carefully strike a balance between these two competing interests is highly desirable.

It is useful to put recent case law developments in context. Delaware courts (where much of the "auction" law has been developed) have long enforced the principle that a fiduciary engaged in the sale of trust assets has a duty to maximize the price received for those assets. That such a principle would be applied to the sale of control of a corporate enterprise seems, in hindsight, rather self-evident.

When the principle was announced in the Revlon Inc v. MacAndrews & Forbes Holdings Inc., 506 A.2d 173 (Del. 1986), however, it sent shock waves through the legal and financial communities and led to extensive scholarly debate. Cases following Revlon expounded on the nature of the duties implicated and focused intensely on the question of precisely when the duties announced there were triggered.

Of greater interest here, however, is that many of the early "Revlon" cases also addressed the contract rights of jilted bidders. The result was disappointing, at least from the perspective of the bidders. For example, in the Revlon case itself, the merger agreement provided Forstmann Little with a lock-up option to purchase certain assets of Revlon and a $25 million "break-up" fee in the event the company accepted a higher bid.

After concluding that the lock-up option was the result of a breach of fiduciary duty by the target directors, the Court of Chancery enjoined both the lock-up and the break-up fee stating that "[t]he link between the escrow of the lock-up assets and the cancellation fee suggests, however, that Forstmann Little and Revlon considered the two as combined security to secure the exclusion of Pantry Pride from further participation." MacAndrews & Forbes Holdings Inc. v. Revlon Inc., 501 A.2d 1239, 1252 (Del. Ch. 1985). The Supreme Court affirmed this decision with almost no analysis of the break-up fee.

The decisions affecting Forstmann Little's rights dwelt almost exclusively on the Revlon board's breach of its fiduciary duties to its shareholders, and contained very little, if any, analysis of the rights of the contract party that sought to enforce its right to its agreed break-up fee. While equity has long been prepared to enjoin the rights of a third party that is knowingly complicit in a breach of fiduciary duty (so called "aider and abettor liability"), the Revlon decision and its progeny, to the extent they affect third parties' rights, appear to stand on only this legal basis for invalidating the contract rights of third parties.

Subsequent contract parties fared little better in the courts. For example, in In re Holly Farms Shareholders Litigation, C.A. No. 10350 (Del. Ch. Dec. 30, 1988), a termination fee of $15 million and expense reimbursement provisions were "enjoined so that the board may carry out its duties under Revlon to maximize shareholder value." Id. at 17. Almost no attention was paid to the rights of third parties in the decision enjoining the payment of the fee, and the jurist deciding the case appeared to justify his interference with the third party's rights solely on the basis that the court had an (unspoken but overriding) duty to the stockholders of Holly Farms to help them achieve the best possible price for their shares.

These issues have been addressed outside Delaware, as well. In ConAgra Inc. v. Cargill Inc., 382 N.W.2d 576 (Neb. 1986) a divided Nebraska Supreme Court addressed the right of a jilted bidder to collect damages for an alleged breach of a "best efforts" clause in a merger agreement, and a contractual undertaking to hold a shareholders' meeting. Holding that the directors of the target corporation "could not" pledge their best efforts to consummate a transaction if doing so violated their fiduciary duties to shareholders, the court reversed the trial court's grant of summary judgment in favor of the jilted bidder and ordered the case dismissed.

Three judges dissented, arguing that the target board's fiduciary duty was met by allowing the shareholders to decide whether they preferred the (nominally) higher all-cash offer of the second bidder, or the tax-free exchange of stock offered by the first. Putting the issue in this perspective, the dissent argued that holding the target to its best efforts and meeting obligations did not do violence to any fiduciary duty. By reconciling the contractual and fiduciary responsibilities, the dissent argued that the trial court's disposition of the matter was essentially correct, giving meaning to the contract while enhancing certainty among arms' length contracting parties.

Perhaps the "high water" mark in this area came in the Delaware Supreme Court's decision in

Paramount v. QVC, 637 A.2d 34 (Del. 1993), which denied a disgruntled bidder's claim that it had certain "vested" contract rights in a no-shop provision and an option-rights agreement. These purported contract rights were extremely valuable. At the time of the decision, the voided option rights were worth some $500 million. The court said that the bidder had no "vested" contract rights to enforce, and went so far as to announce the rule that a contract that was the product of a breach of fiduciary duties was not merely voidable but void, a nullity ab initio.

The court's treatment of the disappointed bidder in QVC did not extend to the invalidation of its $100 million termination fee, but perhaps only because none of the parties had appealed the failure of the Court of Chancery to enjoin the provision. Indeed, the Supreme Court appeared to suggest that it may well have treated that fee differently than the trial court if it had been before the court on appeal.

Against this backdrop, and during the same time, the same courts were generally more solicitous of contract rights where the transaction involved not a sale of control but instead a strategic combination. In 1989, for example, the Delaware Court of Chancery determined not to enjoin the exercise of reciprocal stock options in the original Time-Warner merger transaction even when challenged by an all-cash bidder offering a price arguably higher than that offered in the merger. Paramount Communications Inc. v. Time Inc., C.A. Nos. 10670, 10866 (Del. Ch. June 9, 1989).

Likewise, the courts have routinely upheld reasonable termination fees against stockholder challenges and the Delaware Supreme Court itself, not long after deciding the QVC v. Paramount case, upheld a $550 million termination fee in the Bell Atlantic-NYNEX strategic merger. Brazen v. Bell Atlantic Corp., 695 A.2d 43, 50 (Del. 1997). Until very recently, however, decisions upholding contract rights in the "auction" context were extremely rare, or nonexistent and the pace of auction litigation appeared to have slowed significantly.

It is against this background that several recent decisions appear. These decisions may signal a new and more balanced approach to contract rights, including those that are asserted in the auction context.

In The Kontrabecki Group Inc. v. Triad Park LLC, C.A. No. 16256 (Del. Ch. Mar. 17, 1998), Triad Park, LLC, a Delaware limited liability company holding valuable real estate in the San Francisco Bay area, had entered into a contract to merge with an affiliate of an international real estate developer, The Kontrabecki Group Inc (TKG). The contract between Triad and TKG was struck after a long and active auction process conducted by Triad Park, and only after an earlier bidder was unable to complete a merger transaction prior to the "drop dead date" in its contract with the company.

The merger agreement subsequently entered into between Triad and TKG included a "no shop" clause that prohibited, among other things, the termination of the merger transaction absent a "superior proposal" as defined in the contract. In particular, the TKG/Triad merger agreement required that in order to qualify as a "superior proposal," not only did the competing bid have to be economically superior, but also unconditioned and fully financed prior to its acceptance by the Triad board — i.e., a "definitive unconditioned agreement ... for which financing, to the extent required, is then committed."

The merger agreement also called for the Triad Park board to recommend the transaction to shareholders and to use its best efforts to hold a shareholders' meeting by a date certain. After TKG had mailed its proxy materials to Triad shareholders containing the Triad board's recommendation, and just days before the scheduled vote on the merger, the original contract party re-emerged and announced an apparently unfinanced offer for all shares at a price substantially higher than that offered in the TKG contract and on substantially identical terms.

Asserting (incorrectly, it turned out) that the new bid was a "superior proposal" as defined in the merger agreement, the Triad Park board sent a notice under the contract triggering its right to terminate the merger agreement five business days later in order to accept the "superior proposal."

TKG, now in the role of a potentially disappointed bidder, sued immediately to enjoin the impending termination, arguing that the contract required any "superior proposal" to be both financially superior and fully financed. The contract also required Triad Park to hold a shareholder meeting and to recommend the TKG merger, except on receipt of a "superior proposal." Since the new bidder did not appear to have committed financing in place at the time it made the proposal that the board sought to accept, TKG argued that the target board had no right to terminate the contract or cancel the imminently scheduled shareholder meeting to vote on the merger.

The court agreed and granted a restraining order that both prohibited the board from terminating the merger agreement based on the allegedly nonconforming "superior proposal" and also prohibited any attempt to cancel the impending shareholders' meeting. Finally, the court exercised its equitable powers to require the target board (over strenuous objection) to disseminate immediately to shareholders pertinent information relating to the proposals received, TKG's written responses to the proposals, and the litigation, including the court's disposition of the claims for injunctive relief.

In a ruling that created a result strikingly similar to that advocated by the ConAgra dissenters, the court attempted to strike a careful balance between TKG's rights to enforce its contract and the board's apparent obligation to optimize price in a sale of control. The fulcrum of this balance was the opportunity to allow a fully informed shareholder body to consider and act on a fully financed, firm merger agreement or to withhold their votes in the hope that the second bidder would eventually find sufficient financing to proceed with its proposed bid. The court focused on the importance of the agreement between the parties, stating that: [T]he problem with [the defendant's] argument is to denigrate the significance of a contract. What we have is a firmly worded merger agreement and rights the parties have under that agreement, which would include, under the correct factual and legal record anyway, the option of specifically performing that contract in accordance with your earlier agreement.

* * * I don't know how the fiduciaries could be terribly troubled with a process that puts both these alternatives in the true light of how they appear and appeared before them, before the shareholders for whom they would otherwise act, and ask those shareholders to act based on a fully informed basis. It seems to me that's ultimately what we want in all instances anyway.

Transcript at 43-44. The parties to the lawsuit did not argue, and the facts did not support, any conclusion that the TKG/Triad merger contract was the fruit of any breach of duty by the Triad Park board. In fact, as noted above, the contract was entered only after an active bidding process in which TKG had topped the bid previously submitted by the first and (apparently) favored bidder, and then only after the first bid was terminated by Triad Park after the "drop dead date" in the merger agreement.

The fact that the court was willing to enforce the contract rights of a lower bidder suggests an important shift in judicial focus from fiduciary duties to contract rights. Where previous cases appear to suggest that a board faced with even an arguably higher bid must accept that bid, regardless of whether doing so creates contractual liability, the Triad Park court broke new ground by attempting to balance the contract rights of the bidder in contract against the target board's protestations of impotence in the face of its fiduciary responsibilities to shareholders. In fact, the court's careful and judicious use of its equitable powers to order last-minute dissemination of supplemental proxy materials informing shareholders of late-breaking developments and the parties' positions with respect to the late bidder's lack of financing allowed the shareholders to choose which of the two proposals they preferred. As an economist might well have predicted, the Triad shareholders chose to keep the auction going by voting against the TKG merger. Happily for TKG, the story ended with another round of bidding, which TKG again won, this time closing its transaction.

Perhaps the TKG case was factually driven, even sui generis. The fact that the court was willing to attempt to balance a contract party's rights in the auction context, however, is an important new development and should revive the temporarily moribund debate regarding the value and importance of negotiating provisions of this sort in the context of an outright sale of control.

At roughly the same time that the Court of Chancery was deciding the Triad Park case, the same court declined to intervene in another auction contest that had clearly been tilted in favor of a bidder. In American Business Info. Inc. v. Faber, C.A. No. 16265-NC (Del. Ch. Mar. 27, 1998), the merger contract between the target and its favored bidder effectively allowed that bidder a two-day window after the deadline for submission of bids in which to top any bid submitted by another suitor, which had advised the target of its intention to bid higher than the first bidder and to top by $.25/share any further bid made by that party.

Asked to "level the playing field" between the two bidders and to enjoin the exclusive topping right of the first bidder, the Delaware Chancellor demurred. The court found both a substantial risk that enjoining the existing transaction could lead to the loss of a firm deal for shareholders, and a lack of probable success on the merits. Holding that the record demonstrated that the board had made an honest attempt to maximize value in designing the auction, the court did not expressly rule based on contract law. The result of the court's ruling, however, was to leave intact the challenged contract provisions.

The court seemed little moved by the second suitor's promise to top any bid submitted by the favored bidder by $.25/share, even though a strikingly similar fact pattern appeared to weigh heavily on the Revlon court in making its decision to enjoin a transaction in the face of the second bidder's announced intent to top any offer made by its rival.

Following the trial court's ruling, the parties engaged in further bidding. In light of substantial further factual developments following the preliminary injunction hearing, the Delaware Supreme Court declined to hear ABI's appeal.

While neither Triad Park nor American Business Info. resulted in written opinions or were subject to appellate review, the cases appear to signal the beginning of a critical re-examination of contract rights asserted in the face of competing fiduciary principles. While the last word on the subject certainly has not been written, it does appear that the Delaware Court of Chancery may be more willing to consider seriously arguments made by those holding contract rights in the face of fiduciary law challenges to the enforcement of those rights.

At the very least, it now appears as though the court will no longer merely gloss over such arguments, assuming that, in all cases, the interests of stockholders must necessarily prevail over the interest of contract parties. The tension between these two areas of the law is far from resolved, however. What we may be witnessing is the beginning of a pendulum swing in favor of more serious consideration for the rights of contract parties. Indeed, recent cases may mark the beginning of a trend toward more careful attention to "deal protection" mechanisms in merger agreements and similar contracts.

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