In a recent decision, the Delaware Court of Chancery reaffirmed its reluctance to second-guess the tactical decisions made by a Board of Directors in structuring a sale of the company, so long as the Board has diligently educated itself about its strategic alternatives and the value of its company’s business. The opinion also comments on deal protection measures and other issues common to corporate auctions. In re Toys "R" Us, Inc. Shareholder Lit., Cons. C.A. No. 1212-N (Del. Ch. June 22, 2005, Strine, V.C.).
The case was brought by Toys "R" Us stockholders seeking to enjoin the company’s pending $6.6 billion cash sale to a group of private equity investors led by Kohlberg Kravis Roberts & Co. (KKR). The KKR agreement was the culmination of a nearly year-long effort to evaluate the company’s strategic alternatives. In the course of this process, which included dozens of Board and Executive Committee meetings, the Toys "R" Us Board obtained extensive information about the values of the company as a whole and of its principal divisions and their underlying real estate. The Board originally pursued the sale only of one division, but eventually decided to entertain offers for the whole company from a subset of bidders.
In refusing to enjoin the sale to the KKR-led consortium, the court spoke to various aspects of the corporate sale process, including the following:
- The plaintiffs argued that the Board unreasonably deterred additional offers for the company by granting KKR a $247.5 million break-up fee (equal to 3.75% of equity value or 3.25% of enterprise value), a right to match any later bid for a limited period of time, and a $30 million expense reimbursement if the Toys "R" Us stockholders voted down the KKR deal. The court stated that the directors’ decision to protect the KKR deal in these ways could not be said to be unreasonable, particularly where KKR’s offer was $350 million higher than the next highest bid, the company had negotiated down the break-up fee from 4%, and (in the court’s view) the 3.75% fee plus temporally limited matching rights would not act as a "serious barrier to any bidder willing to pay materially more."
- The court did point out, however, that it would not turn a blind eye to "excessive" termination fees that "present a more than reasonably explicable barrier to a second bidder" and that it would continue to consider deal protection measures in a nuanced, fact-intensive manner. Therefore, the court cautioned that its decision should not be read to indicate that fees lower than 3% are always reasonable. In a footnote, Vice Chancellor Strine also added, "Nor, I believe, should we be entirely immune to the preclusive differences between termination fees starting with a ‘b’ [i.e., measured in billions] rather than an ‘m’."
- In response to indications of interest from some of the bidders for its major division, the Toys "R" Us Board changed course to focus on selling the entire company. At this point, the Board decided to limit the process to only the four bidders that had previously conducted due diligence and submitted bids for the division, in order to avoid losing the "birds in the hand" (the attractive bids received for the division) through a further delay. In approving this tactical decision, the court emphasized that no new bidders had surfaced even after the Wall Street Journal reported that two of the existing bidders had expressed an interest in purchasing the whole company. The court noted that, at this point in the process, any other bidders would have been likely to throw their hats into the ring, given that – in the court’s words - the M&A market is not a "cotillion of the reticent."
- Speaking to the practice of private equity firms pooling their resources in a "club" deal, the court found nothing wrong with the fact that Toys "R" Us approved KKR’s request to join forces with another private equity group (Bain/Vornado) that had been one of the four finalists in the bidding for the division. The court dismissed the plaintiffs’ argument that this so-called "collusion" improperly reduced the number of competitive bidders, stating that this "emerging practice among financial buyers" can help target company stockholders by permitting buyers "to make bids that would be imprudent, if pursued in isolation."
- The court also noted with approval the efforts made to decouple the sale process from discussions about the retention of existing Toys "R" Us management. In the merger negotiations, Toys "R" Us required KKR to remove a condition that existing management be retained to run the company. In addition, the CEO refused to discuss his future employment with any of the bidders. (The court noted that, in the end, he was not offered employment by the winning bidder.)
- More broadly, the court was impressed by the extent to which the Board took pains to educate itself, over a prolonged period, about the value of Toys "R" Us and its constituent parts, and the various alternatives available to the company (including divisional sales and spin-offs). It also cited with approval the fact that the nine independent directors had held occasional executive sessions, excluding the CEO, to consider the company’s alternatives and tactics.
- The court also dismissed attempts to discredit the advice given by Toys "R" Us’ financial advisor, CSFB, on the basis that CSFB would receive higher compensation upon a sale of the whole company than upon a sale of only part.
- The case also touched upon the issue of a target company’s financial advisor providing buy-side financing. Before the KKR agreement was reached, CSFB had asked the Toys "R" Us Board to permit it to contact bidders about possibly providing financing to them. This request was denied. However, nearly two months after the agreement was signed, CSFB was permitted to provide financing to the successful bidder. The court stated that, while this "tends to raise eyebrows," it did not suggest that CSFB’s work before approval of the transaction was tainted. The opinion noted that, under some circumstances, a target Board might conclude that its financial advisor’s willingness to provide financing to bidders – particularly on the same terms to all comers - could actually benefit stockholders by encouraging more bidders to step forward. However, the court cautioned that "[i]t is advisable that investment banks representing sellers not create the appearance that they desire buy-side work, especially when it might be that they are more likely to be selected by some buyers for that lucrative role than by others."
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