Originally published in IDD Magazine, October 2006.
The rationale for deal protection is clear, and this attorney takes a look at recent developments in this area.
It has become common practice to include a "fiduciary out" in negotiated merger transactions. When directors of a target authorize these transactions and bind the company to support them, they are, at least to some degree, usurping for themselves a power that ultimately belongs to the shareholders — namely, the right to choose when and to whom to sell control. By agreeing to restrict the ability of the company to pursue and consummate alternative transactions, the directors are limiting their ability to act in what might later emerge to be the best interests of the company’s shareholders. The introduction of the "fiduciary out" balances this by permitting the directors of the target to withdraw their recommendation of the negotiated transaction and terminate the agreement.
However, this right is not unlimited and comes at a cost. A buyer agreeing to a fiduciary out has a valid concern that its deal not start an auction for the company. Therefore, the ability of the target to pursue and accept a competing transaction is usually carefully circumscribed, and its ability to terminate the transaction typically carries with it an obligation to compensate the original buyer. These restrictions on the fiduciary out are referred to as deal-protection provisions. In each case, the question for the board in agreeing to these provisions is whether they are reasonable in all circumstances.
There are six primary types of deal-protection provisions:
- "No-Shop" and "No-Talk" provisions
- Restrictions on any change or withdrawal of the board’s recommendation
- A matching right for the original buyer
- Lockup agreements with majority shareholders and "Force the Vote" provisions
- Break fees and expense reimbursement provisions
- Asset options and other break fee alternatives
As we all know, merger activity has accelerated significantly in North America over 2005 and 2006. As a result, we have seen some new developments and some high-profile examples of the operation of deal-protection provisions.
There have been relatively high break fees in recent transactions (including 3.5% in the Inco/Falconbridge deal and 4% in the Arcelor agreement to acquire Dofasco). This is, in part, a reflection of the increased M&A activity and acquirers’ concern that they will be merely starting an auction for the company that they may ultimately lose.
These cases are also good examples of situations in which a higher fee may be justifiable. In the Inco/Falconbridge deal, Xstrata held just less than 20% of the outstanding shares and was rumored to be a potential bidder. Its presence arguably made it more difficult for the target to attract offers from competing bidders, and therefore necessary to provide a greater incentive to Inco to put its offer forward. In any event, as the facts played out with Xstrata’s recent successful topping bid, it became clear that the amount of the fee did not preclude a superior proposal.
In the Arcelor/Dofasco case, the board of Dofasco entered into a deal with ThyssenKrupp at a premium but without engaging in an auction for the company. Dofasco agreed to a 2% fee with ThyssenKrupp, which is at the lower end of the spectrum. Dofasco ended up commanding a much greater price, and an active bidding war ultimately led to Arcelor’s successful transaction. The heated competition between the bidders arguably justified the higher fee when Dofasco eventually agreed to support the Arcelor bid.
Lower break fees are still present, however, particularly in bids for income trusts and REITs, where the target is limited by its need to distribute available cash.
Dealing with Regulatory Risk and Other Deal Protections for the Target
The successful bid by Whirlpool for Maytag included a "reverse" break fee. In that case, Maytag had an offer in hand from Ripplewood, a private equity fund. Although Whirlpool subsequently put a better offer on the table, the merger of Maytag and Whirlpool raised significant antitrust issues. The process for obtaining the necessary approval was expected to be protracted and difficult, and the board of the target wanted protection if the Whirlpool deal ultimately failed, because the target would have given up an offer from Ripplewood and suffered significant disruption to its business. Therefore, Maytag negotiated a reverse break fee that would have required Whirlpool to pay $120 million (or 7% of the deal amount) to Maytag if the transaction did not receive antitrust approval on terms satisfactory to Whirlpool. Ultimately the Maytag/Whirlpool transaction was successful.
Although on a lesser scale, AO Smith’s acquisition of GSW included a somewhat similar fee payable by AO Smith to GSW. That transaction also involved significant antitrust risks, and therefore the parties sought regulatory approval before GSW entered into any agreement with the bidder. In addition, the majority shareholders negotiated a right to refuse to proceed with the regulatory review process if it extended beyond a fixed date unless AO Smith made a payment to the company to help defray the costs of the process.
The battle for Falconbridge involved another situation in which antitrust risk figured largely in the battle for control and in which the target faced unique risks. Inco made its original offer for Falconbridge in October 2005. However, because the transaction raised significant antitrust issues, the bid had to be extended into the summer of 2006. Inco and Falconbridge were concerned that Xstrata, which held just under 20% of the outstanding shares, would acquire sufficient additional shares to block the Inco transaction. Therefore, when the Falconbridge shareholder rights plan expired during the regulatory process before Inco could complete its transaction, Falconbridge introduced a new shareholder rights plan so that Xstrata would not be able to increase its position. Xstrata did eventually make a formal bid and indicated its intention to buy shares in the market if the rights plan was waived or the rights ceased to be traded. Xstrata then applied to the Ontario Securities Commission to cease trade the plan. The commission refused to do so until the Inco bid had expired, on the basis that Xstrata’s acquisition of additional shares might interfere with Inco’s bid and therefore shut down the auction for the company.
The HCA transaction also includes a type of "reverse" fee. In that agreement, the acquirer is a newly formed company sponsored by a consortium of private equity funds. It agreed to pay the negotiated termination fee ($500 million) to the target if the acquirer fails to close as a result of its own breach. Here the reverse fee operates as a type of liquidated damages provision that would relieve the target from proving damages and also allow the private equity sponsors to limit their potential liability.
Although public M&A deals with fiduciary outs typically prevent the target from soliciting competing bids, as described above, there are exceptions. A "go-shop" provision allows a target that has entered into a support agreement with an acquirer to shop the company, usually for a limited purpose. A no-shop provision would prevent that. A target may negotiate a go-shop provision if it has not canvassed the market and believes it needs the opportunity to test whether it has obtained the best value. The most notable recent example in the US is the proposed acquisition of HCA. The Maytag/Ripplewood transaction is another US deal that included a go-shop.
Canadian examples of these provisions are still somewhat rare, but recent ones include Algonquin Power’s bid for AirSource Power Fund and Vector’s acquisition of Corel. In the AirSource example, Algonquin (the offerer) was the manager and founder of the fund. It made an offer but gave the "liquidity committee" of the fund the right to continue to solicit a better transaction. In the Vector/Corel example, the parties entered into nondisclosure and standstill agreements under which Corel agreed to support a Vector bid above a specified price (subject to receipt of a favorable fairness opinion). The parties agreed to negotiate a definitive agreement, and Corel had the right to solicit other offers.
The key negotiated elements of these go-shop provisions are the duration of the solicitation period and whether a break fee will have to be paid if the target is successful. HCA allowed 50 days for the go-shop right, compared with 30 days in the Maytag and Corel examples. In the HCA deal, a break fee will have to be paid if HCA secures a better offer, but the fee is lower during the go-shop period ($300 million compared with $500 million if a better offer emerges after the end of the go-shop period). Under the Maytag/Ripplewood deal, Maytag was required to pay Ripplewood a break fee of $40 million as a condition of accepting Whirlpool’s topping bid. No break fee was payable in the Corel or AirSource deal (and both those transactions proceeded with the original offerer).
These types of arrangements are still unusual, and acquirers can be expected to strongly resist them.
Changing Recommendation and "Force the Vote" Provisions
In a negotiated deal, the target board is typically not permitted to change its recommendation unless it has received an unsolicited superior proposal. And if it changes its recommendation, it is typically not required to proceed with any shareholder meeting called to approve the transaction. However, in the acquisition of Leitch by Harris Corp., Harris agreed that the Leitch board would be allowed to change its recommendation in the absence of a superior proposal, but Harris would have the right to "force the vote" on its deal. If the board had exercised its right to withdraw its recommendation, Harris would have been entitled to terminate the agreement and receive the break fee. If Harris had chosen not to terminate in those circumstances, the Leitch board would still have had to proceed with the meeting and allow the shareholders to vote on the Harris deal even though the board would not have been recommending approval. However, Leitch would have been released from its obligations to solicit proxies and take reasonable action to obtain shareholder approval.
There have been recent Canadian examples of irrevocable lockup agreements with majority shareholders. Lukoil’s acquisition of Nelson Resources is one case, although in that situation, the acquirer dispensed with the intermediate step of entering into a lockup agreement and simply acquired the shares held by the majority shareholders. The shares represented 65% of the outstanding stock. Lukoil was able to acquire them under the private agreement exemption without making a formal bid for all the shares because it was purchasing from five or fewer sellers at a price that did not exceed 115% of the market price at the time (this type of transaction is exempt from Canadian takeover bid rules). Lukoil then approached the company with an amalgamation proposal to squeeze out the remaining publicly held shares, in circumstances in which the alternatives available to the target were limited. In particular, it was clear that Lukoil would not be prepared to sell the block, so the company was not in a position to seek an alternative purchaser of control.
Another recent example was AO Smith’s acquisition of GSW. In that case, the majority shareholders together held more than two-thirds of each class of outstanding shares and agreed irrevocably to tender to the AO Smith offer. The bidder agreed to extend the offer to all shareholders at the same price per share, so it was in a position to complete a second-stage transaction to acquire the remaining shares by carrying the majority vote. The success of that second-stage acquisition was therefore largely ensured at the time AO Smith made its offer. The acquirer nonetheless insisted on a support agreement with GSW as a condition of making the offer, and GSW agreed to provide that support. Although the GSW board retained the right to provide information to a third party making a superior proposal and to withdraw its recommendation in favor of that superior proposal, the board noted in the directors’ circular that the likelihood of a superior proposal was remote given the irrevocable lockup agreements. GSW did not agree to a "force the vote" provision or otherwise limit its right to interfere with the transaction if a better offer were made.
Yet another recent example is the Bell Globemedia bid for CHUM. Although the lockup is revocable in that case, the majority shareholders of the target negotiated the price and terms of the lockup and support agreements with the acquirer before the acquirer presented its offer to the target, rather than negotiating with the target and the majority shareholders concurrently. The acquirer’s obligation to proceed with the offer was, however, conditional on the target’s entering into the support agreement and providing the acquirer with access to confidential information.
More Tests Coming
If the current level of M&A activity continues, we can expect further bidding wars that test the deal-protection provisions of negotiated merger agreements and inspire bidders to become more creative in structuring transactions. The objective is to avoid extended auctions that could result in a failed transaction or to ensure that the acquirer is highly compensated in that event. The countervailing tension is a strong desire by directors to ensure that they are complying with their fiduciary duties and are not leaving themselves open to criticism.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.