Published in North American Corporate Lawyer, vol. 7, no. 3, 2003
A Delaware court recently concluded in Omnicare1 that the board of directors of a Delaware company cannot approve an irrevocable merger agreement, even if the merger is not available except on that basis. If a similar case had been before a Canadian court, the result would likely have been different. Nevertheless, I believe the case will have an impact on negotiated merger transactions in Canada as well as in Delaware and other U.S. jurisdictions.
Omnicare and the Delaware Position
The Omnicare case involved NCS, a health-care company in financial difficulty. After exploring strategic alternatives and negotiating unsuccessfully with Omnicare, NCS entered into a merger transaction with Genesis. The NCS board determined that the Genesis deal was the only reasonable alternative, and the holders of a majority of the NCS voting shares irrevocably agreed to support the transaction (these irrevocable voting lockups were a requirement of Genesis)2. Although the NCS board was permitted to withdraw its recommendation of the Genesis deal if a better offer emerged (and eventually did so), NCS had also agreed to hold a meeting of shareholders to consider approval of the merger even if the board withdrew its recommendation. With the irrevocable voting lockups, this commitment to hold the meeting made the required approval of the deal by the shareholders a certainty.
Once the Genesis deal became public, Omnicare announced a bid at a substantially higher price, conditional on the Genesis deal being struck down. A majority of the Court struck down the Genesis deal, even though it appeared to accept that the NCS directors genuinely believed, in the exercise of their best business judgment, that (i) Genesis would not have made its offer without certainty that the deal would close; and (ii) if Genesis had not made its offer, Omnicare’s offer would not have been available to the NCS shareholders, who would have received nothing for their shares.3
The Court held that any defensive devices that might affect the shareholders’ right to "effectively" vote contrary to the board’s initial recommendation are subject to special scrutiny under the two-part test in Unocal.4 Under the Unocal test, the Court examines (i) the adequacy of the process; and (ii) whether the defensive actions were "within the range of reasonableness." However, the Court found that if the defensive measures were "preclusive" (if they preclude any other transaction) or "coercive" (if any defensive action coerces other shareholders to accept the transaction), they would necessarily fall outside the range of reasonableness.5 The Court examined the irrevocable shareholder voting lockups and the agreement to force a vote for approval of the merger,6 striking them down on the basis that their combined effect was both preclusive and coercive because they made it impossible for any superior proposal to succeed.
The Court also found, in the alternative, that the defensive measures included in the Genesis deal were unenforceable because they would necessarily have prevented the board from making a subsequent superior offer available to minority shareholders. The Court recognized that the majority shareholders had an absolute right to vote their shares in favour of the Genesis transaction, but found that this did not alter the board’s responsibility.7 Implicit in this decision is that a board must reject a transaction if it is unable to negotiate an effective fiduciary-out (or the minority cannot vote down the deal), even if the board believes that the deal is in the best interests of the shareholders and may be the only transaction available.
The dissenting judges in Omnicare characterized the majority decision as imposing a new rule that a merger agreement that locks up stockholder approval and does not contain an effective fiduciary-out is per se invalid when a later significant topping bid emerges, regardless of the circumstances. They thought that the Court should instead simply apply the business judgment rule and that there should be no "special duty" to protect the minority from a controlling shareholder’s ultimate decision unless the board found itself in a conflict of interest in exercising its business judgment. Even if the dissenting judges had applied the Unocal analysis, they would have found that the defensive measures were necessary to obtain the original deal and therefore were "within the range of reasonableness."
The Canadian Position Is Different
In my view, a Canadian court would have favoured the approach of the dissenting judges over that of the majority in Omnicare.
Canadian Business Judgment Rule
The Canadian courts have consistently applied the business judgment rule to defer to the business judgment of the board.8 To the extent that applying the business judgment rule would lead to a different result, they have rejected the "enhanced" standard of scrutiny applied by some U.S. courts and have upheld defensive tactics provided that the board acts on an informed basis, in good faith and free of conflict.9 Most important, courts in both Ontario and Quebec have recognized that a board of directors may decide not to proceed with an auction if it believes that doing so might risk the withdrawal of an existing offer.10 That was the circumstance in Omnicare.
Majority Shareholders Can Act in Own Interest
The Delaware court was not persuaded by the argument that the majority shareholders were entitled to vote their shares as they wished, and held that the board was nevertheless bound to ensure that minority shareholders could accept a higher offer if one should be made later.11 However, the Canadian courts have consistently upheld deals in which the target board has rejected a transaction because it does not have the support of shareholders who could effectively block the deal, or deals, in which the majority shareholders have irrevocably locked up. This is the case even where dual voting share class structures, similar to that of NCS, were present. Canadian courts have accepted that the board may be faced with a narrower range of options (only those the majority shareholder would support) and that the directors can take this into account in determining which transaction to support (if any).12
Impact of Omnicare on Canadian Practice
Canadian practitioners typically advise target boards to obtain an effective fiduciary-out. Since the late 1990s, public M&A deals in Canada have generally included a fiduciary-out in both the merger agreement and any related shareholder lockups,13 and bidders have been prepared to accept that position. As well, the range of typical "defensive protections" has narrowed in recent years. In agreeing to relatively standard fiduciary-outs, bidders have generally insisted on cash "break fees" as a price of putting their deal on the table. Accordingly, the board’s exercise of its fiduciary duties has focused on its approval of these fees.14
Before Omnicare, Canadian practitioners would nevertheless have advised target boards that, in the right circumstances, the board could support a merger without an effective fiduciary-out. In my view, this remains the law in Canada, but as a result of the issues raised by Omnicare, offerors may have greater difficulty obtaining irrevocable agreements from target boards even when the board believes there is no better alternative for the shareholders. Where a deal is not available except with this type of deal protection, practitioners may advise target boards to insist that bidders proceed by way of a two-step transaction and rely for deal certainty on irrevocable agreements with the major shareholders.15
Canadian merger transactions are often carried out as a one-step transaction with shareholder approval (such as by amalgamation) because one-step transactions may be easier to finance and often have tax benefits. Under a two-step approach, the acquiror makes a formal takeover bid and acquires any shares not tendered either by a subsequent compulsory acquisition (typically available if the acquiror obtains at least 90% of the shares) or by an amalgamation "squeeze out" (typically requiring approval by holders of two-thirds of the shares). The target might still agree to support a one-step merger, but the board would have a standard fiduciary-out. If the board exercised its fiduciary-out and withdrew its support of the merger in favour of a competing offer, the acquiror could still make a formal takeover bid on the same terms and any shareholders who had signed lockup agreements to vote in favour of the merger would be required under those agreements to tender their shares to the bid.16 If those agreements were irrevocable, even if the target board withdrew its recommendation and there were no provision requiring it to put the merger to a vote, a competing higher bid would appear to have no chance of success. If the original merger party acquired a sufficient majority of the shares, then under the current Canadian rules it could force completion of a second-step transaction to "squeeze out" the remaining minority shares even in the face of a higher competing bid.17
The theory for such a structure is that regardless of one’s interpretation of Omnicare, it should not interfere with the right of a shareholder to sell its shares. The question is whether a two-step alternative transaction would nevertheless offend the principles laid down in Omnicare because the combined effect of the arrangements would effectively preclude a subsequent competing bid.
Some U.S. practitioners are taking the position that a merger agreement coupled with an irrevocable lockup by a major shareholder (requiring a vote in favour of a merger or a tender to a takeover bid by the merger party) will not be struck down unless there is provision for a "forced vote" by the shareholders on the merger (i.e., a vote in circumstances under which the directors have withdrawn their support). To support this narrower interpretation of Omnicare, these practitioners may point to the provisions of Delaware law, which require a merger to be "approved and declared advisable" by the board before being put to a shareholder vote, and to the majority’s criticism in Omnicare of the NCS board’s agreement to exercise its statutory power to force a vote even if it no longer believed that the merger was advisable.18 In theory, the lack of any agreement to hold a shareholders’ meeting to effect the second step would put the ultimate success of the transaction at risk and increase the possibility of a successful competing offer, giving the fiduciary-out "teeth" so it meets the Omnicare test of being "effective."
To the extent that this interpretation of Omnicare is correct, it is less relevant in Canada, where the legal requirements for effecting a merger are different. Under Canadian law, these transactions must generally be submitted to the shareholders for approval (as opposed to approved and declared advisable), and a shareholder can requisition a meeting to consider the merger if the board will not do so.19 Therefore, even with the two-step structure described above, the bidder will not require board support to force a shareholder vote and will know at the front end that it can carry the shareholder approval at the back end.20
In Omnicare, the NCS board believed that it risked losing the only deal that would provide value to shareholders if it did not agree to the deal protection measures required by Genesis. The Court nonetheless concluded that the board should not have agreed to those deal protections. The Court’s approach would have resulted in no deal for shareholders. It is difficult to see that this result would have been in the shareholders’ best interests.
As a matter of principle, Canadian companies have the flexibility under applicable Canadian law to agree to a transaction with deal protections that result in the certainty of the completion of that transaction (recognizing that in order to do so, shareholders holding a substantial number of shares must be in agreement). Whether a board will have complied with its fiduciary duties in doing so will depend on the particular circumstances and, like their U.S. counterparts, Canadian boards will likely resist such arrangements, even where they make business sense, because of the risk of litigation if a better offer emerges. But where shareholders agree, some deal will be better than no deal at all.
Footnotes1. Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003) [Omnicare]. 2. NCS had a dual voting share class structure under which these holders held shares representing over 65% of the votes, but only approximately 20% of the equity of NCS. 3. Omnicare, supra note 1 at 924-925, 938-939. It is somewhat difficult to understand why the board withdrew its recommendation in the circumstances of the case (where approval of the transaction was inevitable), or why it purported to retain the right to withdraw its recommendation, given that it had effectively irrevocably bound the company to the deal, acting in what it determined at the time was the best interests of the shareholders. Although the decision did not mention this factor, retaining and exercising the right to withdraw its recommendation may have unwittingly hurt the board’s credibility in later arguing that it believed the Genesis deal was the only available deal and would not be available without the agreed defensive provisions. 4. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) [Unocal]. 5. Omnicare, supra note 1 at 934-936. 6. The Delaware corporate statute (Delaware Code § 231(c) (2003)) was recently amended to allow a merger transaction to be put before shareholders even where the board no longer recommends it. The Genesis merger agreement required the board to invoke that section if it withdrew its recommendation. Nevertheless, the majority attacked this "forced vote" provision in particular and found that although the board had the power under corporate law to put the decision to the stockholders, it would not necessarily fulfill its fiduciary duties by doing so. 7. Omnicare, supra note 1 at 936-939. 8. See Brant Investments v. KeepRite (1991), 80 D.L.R. (4th) 161 (Ont. C.A.), aff’d (1987), 42 D.L.R. (4th) 15 (Ont. H.C.); CW Shareholdings Inc. v. WIC Western International Communications Ltd. (1998), 160 D.L.R. (4th) 131 at 152-67 (Ont. Gen. Div.), Blair J. [WIC]; and Maple Leaf Foods Inc. v. Schneider Corp. (1998), 42 O.R. (3d) 177 at 190-94 (C.A.) [Schneider]. Canadian securities regulators may also review defensive measures and have set out their approach in National Policy 62-202, "Take-Over Bids – Defensive Tactics" (1997), 20 O.S.C.B. 3525. The policy articulates a less deferential approach, which recognizes that a board may appropriately invoke defensive measures in "genuine search of a better offer" but goes on to state that tactics that are "likely to deny or limit severely the ability of shareholders to respond to a take-over bid or to a competing bid" may result in action by the regulators. (It is not at all clear that this requirement would be applied in the circumstances of Omnicare.) However, with the exception of hearings to consider cease trading "poison pills," there have been few occasions in recent years where regulators have become involved in reviewing such defensive measures. 9. WIC, supra note 8 at 152-167. But see 347883 Alberta Ltd. v. Producers Pipelines Inc. (1991), 80 D.L.R. (4th) 359 (Sask. C.A.). 10. Schneider, supra note 8 at 199-202; Cogeco Câble Inc. v. CFCF Inc.,  R.J.Q. 1360 (QC. Sup. Ct.) [CFCF]. 11. The majority may have been influenced by the fact that the shareholders who signed the voting lockups held shares that represented a much higher percentage of the votes than of the equity of NCS. They noted, for example, that the public "owned 80% of NCS and overwhelmingly supported Omnicare’s offer" yet "will be forced to accept the merger." Omnicare, supra note 1 at 935-936. 12. Benson v. Third Canadian General Investment Trust Ltd. (1993), 14 O.R. (3d) 493 at 499-500, 512 (Gen. Div.); Armstrong World Industries Inc. v. Arcand (1997), 36 B.L.R. (2d) 171 at 177-78. (Ont. Gen. Div.); Schneider, supra note 8 at 204-205; and CFCF, supra note 10 at 1378, 1381, 1383. In both Schneider and CFCF, the majority shareholder held multiple voting shares representing a majority of the votes but less than a majority of the equity of the relevant target company. 13. As a practical matter, funds or institutions often hold significant blocks and are usually unwilling to agree irrevocably to vote in favour of a transaction because of their own role as fiduciaries for their investors. 14. Break fees could be challenged in Canada by seeking a cease trade order from the securities regulators under National Policy 62-202 (which sets out the basis on which the regulators will review defensive measures). Under that Policy, the regulators would consider the reasonableness of the fee and its impact on potential competing bids. As well, the fee may be challenged in the courts as oppressive but, as outlined in this article, the board’s decision would presumably be accorded judicial deference if it acted in good faith, without conflict and honestly believing that the deal was in the corporation’s best interest. The author is not aware of any Canadian case striking down or cease trading a transaction on the basis of the amount of the break fee. In Sunlife’s recent bid for Clarica, for example, the termination fee attracted significant negative attention, with one institutional holder refusing to vote in favour of the transaction because of the magnitude of the fee. However, the fee was never formally challenged and the transaction was successfully completed. 15. In Schneider, supra note 8, the target decided to move from a one-step plan of arrangement to a two-step transaction because a plan of arrangement requires court approval. The target board had obtained financial advice that the offer was at a price below the fair value range and therefore was unwilling to hold out to the Court that the transaction was "fair" (even though the board believed the transaction to be in the best interests of the shareholders). This shift in the structure was one of form not substance and, in principle, should have made no difference to the Court’s decision. Unfortunately, although the Court of Appeal referred to the change in structure and the board’s reasoning, it refrained from commenting on whether the change affected its decision, leaving open the implication
that the one-step plan of arrangement would not
have succeeded. 16. Voting lockup agreements already typically include an agreement by the shareholder to tender to a takeover bid by the acquiror if the latter decides to proceed by formal bid. However, as noted above, the agreement to vote and to tender is normally subject to the target board’s fiduciary-out. 17. The detailed going private rules in Rule 61-501 of the Ontario Securities Commission would require a substantial shareholder who is effectively acquiring the target to obtain a formal valuation and minority approval. However, those rules exempt second-step squeeze-out transactions from the valuation requirement and permit a bidder’s shares to be counted toward the minority approval where the bidder acquired the shares on a front-end takeover bid. 18. Delaware Code § 251(b) and (c) (2003). If Genesis had proceeded by way of a two-step transaction without a forced vote but with irrevocable tendering agreements from the controlling shareholders, the NCS board would have had to determine, before putting the second-step merger to a shareholder vote, whether it could "declare advisable" the merger. The merger may also have required minority approval (see infra note 20). 19. Canada Business Corporations Act, ss. 183(1) and 143, as amended. Similar provisions exist in the provincial corporate statutes. 20. As pointed out in supra note 17, Rule 61-501 of the Ontario Securities Commission permits a bidder’s shares to be counted toward minority approval of the second-step squeeze-out transaction. By contrast, if a business combination is being proposed under Delaware law by a shareholder with 15% or more of the outstanding voting shares within three years of the shareholder’s becoming a 15% or greater holder, the combination must be approved by holders of at least 66 2/3% of the remaining shares, unless the significant shareholder had board approval to acquire the block or had acquired at least 85% of the outstanding shares held by non-insiders in the transaction in which a shareholder became a 15% or greater holder. Delaware Code § 203 (2003). The board’s fiduciary-out could presumably also allow it to refuse approval of the shareholder lockups, thus possibly forcing a Delaware acquiror to obtain minority approval of any subsequent squeeze-out merger and making its success substantially less certain than would be the case in a Canadian context.
Sharon Geraghty is a partner and Corporate Department coordinator of the Toronto office of Torys LLP. Sharon gratefully acknowledges the assistance of Jim Turner, Andy Beck, Sunny Sodhi and Sue-Ann Fox in the preparation of this article.
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