Recent Delaware Case Law May Have a Lasting Impact on the Engagement of Financial Advisors and Related Disclosures in Public M&A Transactions, Contributed by Stephen M. Gill, Vinson & Elkins L.L.P.
by Stephen M. Gill, Vinson & Elkins L.L.P.
A pair of recent Delaware court decisions has shined a spotlight on the role of financial advisors in public M&A. This article summarizes these developments and provides some helpful insight on the impact these cases could have regarding investment banking engagements, proxy statement disclosures, and changes to merger agreements themselves.
Disclosure of Success Fee Arrangements
There is a tension in financial advisor compensation in any M&A advisory engagement. From the company’s perspective, there is a strong possibility that the extraordinary transaction being considered will never come to fruition and it certainly does not want to be saddled with large expenses in that case. The company, however, wants to make sure that it has the best advice it can obtain, from an expert who is motivated to be there during this potential “bet the company” moment. In other words, the company wants the full attention of its financial advisor for several weeks or months, yet does not want to pay a substantial fee to the financial advisor if a deal doesn’t happen. From the financial advisor’s standpoint, consideration of these deals takes a significant amount of time and effort and, as importantly, has the significant opportunity costs of making the financial advisor unavailable for other transactions.
The success fee is a creative solution for both companies and their financial advisors. By paying a substantial portion of the fee only if the deal happens, the company reduces its expenses in a failed sale or auction. In addition, because, at least in the context of a target’s financial advisor, the advisor’s fee increases as the price to the stockholders increases, the advisor is incentivized to push for the highest price. On the flip side, because success fees are typically between 0.2 percent and 1.0 percent of the equity value (depending on the size of the deal), the fees a financial advisor can earn on one successful M&A transaction can more than pay for the foregone advisory fees for several busted deals. A 0.4 percent fee on a $5 billion deal earns the financial advisor a healthy $20 million fee.
While the success fee arrangement is mutually beneficial to both the company and its financial advisor, there is an inherent conflict when the advisor is also asked to opine as to the fairness of the transaction, knowing that receipt of an opinion that the transaction is fair is either explicitly or implicitly a condition for the transaction. Since Smith v. Van Gorkom,1 it has been standard operating procedure in public M&A transactions for a company’s board to insist on a fairness opinion prior to the board recommending the transaction to the stockholders.2 Often a fairness opinion will also be required from the buyer’s financial advisor, particularly where stock consideration is involved. In such a circumstance, the financial advisor will only earn its success fee if it opines that the transaction is fair. Given the obvious financial incentive of the opinion-giver to find the transaction to be “fair,” and the potential questions surrounding a financial advisor’s objectivity and self-interest, Delaware law has long held that proxy statements for transactions in which a fairness opinion is rendered must disclose the compensation arrangement between the company and its financial advisor.3
— In re Atheros Communications
The extent of the required disclosure of success fee arrangements to the stockholders was partially addressed in the Delaware Chancery Court’s recent decision involving Qualcomm, Inc.’s proposed cash buyout of Atheros Communications, Inc.4 Atheros stockholders sought to enjoin the merger alleging that the Atheros board failed to satisfy its fiduciary duties under Revlon5 and that the proxy contained incomplete disclosure concerning, among other things, the fee arrangement between Atheros and Qatalyst Partners LP, Atheros’ financial advisor. The court refused to enjoin the merger on process grounds, but did temporarily enjoin the stockholder meeting until additional disclosure was made concerning, among other things, the contingent success fee arrangement with Qatalyst.
Atheros and Qatalyst negotiated the engagement arrangement from early September until December 28, 2010. During this period of time, despite the lack of a formal engagement agreement, Qatalyst was active on behalf of Atheros in both the negotiations with Qualcomm and communications with alternative bidders. The final fee arrangement was substantially lower than Qatalyst’s original proposal but provided for a very large portion of the fee to be contingent on the transaction closing.6
The original proxy statement disclosed that Qatalyst would “be paid a customary fee, a portion of which is payable in connection with the rendering of its [fairness] opinion and a substantial portion of which will be paid upon completion of the Merger,” but did not disclose either the aggregate amount of compensation or that 98 percent of the consideration was contingent on the consummation of the transaction.7 In enjoining Atheros from holding its stockholder meeting until additional disclosure could be made regarding the significance and amount of Qatalyst’s fee that was contingent, Vice Chancellor Noble wrote that “[t]he differential between compensation scenarios may fairly raise questions about the financial advisor’s objectivity and self-interest. Stockholders should know that their financial advisor, upon whom they are being asked to rely, stands to reap a large reward only if the transaction closes and, as a practical matter, only if the financial advisor renders a fairness opinion in favor of the transaction.”8
Three days after the court’s decision, Atheros made curative disclosure and Vice Chancellor Noble lifted the injunction. The Atheros stockholder meeting was delayed a total of 11 days, and the stockholders overwhelmingly approved the merger.
— Disclosure Implications
While the knee-jerk reaction to In re Atheros may be for companies to insist on disclosure of the contingency percentage of the financial advisor’s fees, financial advisors will continue to be protective of information concerning their fees for precedential reasons. What is clear, however, is that plaintiff firms will allege a disclosure deficiency, citing In re Atheros, any time the proxy statement fails to disclose the contingency ratio. Thus, although the court made clear it was not establishing a bright-line rule, only that “it is clear that an approximately 50:1 contingency ratio requires disclosure,”9 both companies and their financial advisors need to consider at the engagement stage whether the contingency portion of the fee structure is material and thus must be disclosed in a future proxy statement.
Investment Banker Conflicts of Interest: In re Del Monte Foods
The factual background and dispute surrounding the recent acquisition of Del Monte Foods Company by three private equity firms is, by now, well known to M&A practitioners. In a shareholder suit related to the proposed merger, the Delaware Chancery Court found that, unbeknownst to the Del Monte board of directors, Del Monte’s financial advisor manipulated the sales process in an apparent effort to secure not only advisory fees from Del Monte, but also buy-side financing fees from the acquirer.10 Among other things, Vice Chancellor Laster found that Del Monte’s financial advisor failed to disclose to Del Monte:
- the extent of its relationships with several of the private equity firms likely to bid for Del Monte;
- the unauthorized efforts by the Del Monte relationship banker to put Del Monte into play both initially and after an initial auction process failed;
- the financial advisor’s plan to secure the buy-side financing from the acquirer; and
- the financial advisor’s pairing of the private equity firm that had been the highest bidder in the initial auction with another private equity firm with whom the advisor had the strongest relationship, in violation of a “no teaming” provision in the confidentiality agreement.11
This was all done in the context of a Revlon transaction in which, upon the advice of the financial advisor, Del Monte adopted a single-bidder strategy with a go-shop.12 The financial advisor was granted permission to provide buy-side financing (which it had already effectively lined up with the acquirers) prior to final negotiation on price and insisted, because of the conflict of interest, that Del Monte obtain a second fairness opinion (which cost Del Monte an additional $3 million upfront).13 Lastly, the financial advisor was permitted to run the go-shop process despite the fact that this assignment would require the advisor to attempt to drum up topping bids that might result in its loss of the lucrative buy-side financing fees—a direct financial conflict of interest.14
As a result of this record, Vice Chancellor Laster granted the plaintiffs’ motion for a preliminary injunction, finding that they had established a reasonable probability of success on a claim of breach of fiduciary duty by the Del Monte directors and aiding and abetting by one of the private equity firm acquirers. In particular, the court found that, “[b]y failing to provide the serious oversight that would have checked [the financial advisor's] misconduct, the directors breached their fiduciary duties.”15 Vice Chancellor Laster was sympathetic to the Del Monte board, noting that “[o]n this preliminary record, it appears that the Board sought in good faith to fulfill its fiduciary duties, but failed because they were misled” by their financial advisor.16 However, noting that in these circumstances, the directors faced little chance of monetary liability, the Vice Chancellor nevertheless found that “[f]or purposes of equitable relief, the Board is responsible.”17
In addition, the court found unreasonable the Board’s decisions to (1) allow the financial advisor to team up a previous high bidder with the new single bidder without any benefit to the company (e.g., no price increase or other concession), and (2) allow the financial advisor to join in the buy-side financing while in the middle of negotiations on price “[w]ithout some justification reasonably related to advancing stockholder interests.”18 Lastly, the court found that the involvement of the conflicted financial advisor in conducting the go-shop tainted that process.19
The remedy crafted by the court was to (1) delay the Del Monte stockholder vote for 20 days, and (2) enjoin the enforcement of the key deal protection provisions (no-shop, match rights and breakup fee) in the merger agreement while the stockholder vote was pending.
— Implications for Investment Banking Engagements
Future boards that find themselves in a position similar to Del Monte’s board (e.g., asked to accede to a joint bidding request or to allow its financial advisor to participate in the buy-side financing) should be guided by the overarching message in Vice Chancellor Laster’s opinion: agreeing to a financial advisor’s request must be consistent with the board’s charge to maximize value for its stockholders. While the immediate impact of Del Monte will be to seriously curb the participation of a company’s financial advisor in buy-side financing, it does not stand for the proposition that such arrangements are per se prohibited.20 Indeed, if such an arrangement would increase the purchase price the would-be acquirer would pay or, more realistically, salvage the financing for the deal, a board may reasonably permit such an arrangement. One could imagine similar scenarios where allowing the financial advisor to “marry” two bidders to solidify the transaction, reduce consummation risk, or create other value for the target could similarly be in keeping with the board’s duty to maximize value for the stockholders.
In terms of the engagement of the financial advisors, cases like Del Monte underscore the need to involve legal counsel early in discussions with company financial advisors and will have an impact on the way in which companies choose those advisors. At a minimum, companies must address the topic of potential conflicts of interest during the initial interviews with potential financial advisors. I would also expect, post-Del Monte, to see companies begin to push harder and attempt to obtain all (or at least some) of the following provisions in the engagement letter:
- representations (1) that the financial advisor has not had discussions with third parties regarding a potential merger or similar transaction involving the company, and (2) detailing the extent of any relationship that the financial advisor has, or has recently had, with certain entities that the company specifies as being potential transaction partners;
- agreements that the financial advisor will:
- decline to serve as an advisor to any person other than the board (or, in some cases, the special committee) related to the potential transaction;
- promptly detail to the board any meaningful relationship it has, or has recently had, with any third party that expresses interest in the potential transaction;
- decline to arrange or provide financing to potential acquirers without the board’s consent;
- seek board approval prior to allowing two interested parties to share information or bid jointly;
- make the senior banker available for depositions in the event of subsequent litigation challenging the merger or the financial advisor’s fairness opinion;21
- share a portion of the opinion fee to be paid to the financial advisor if the company is later determined to need a second fairness opinion due to such financial advisor’s conflict of interest; and
- a provision that eliminates the obligation to reimburse the financial advisor for its expenses in circumstances in which the financial advisor breaches the engagement letter.
If a board finds itself in a circumstance where its financial advisor becomes conflicted in the middle of the transaction, the board should strongly consider hiring a second, independent investment bank. As noted above, the inclusion of a clause in the engagement letter that provides that the additional costs effectively reduce the initial financial advisor’s fee will help mitigate the additional expense.22
— Merger Agreement Implications
Deal lawyers, like generals, can often be accused of “fighting the last war.” That is, we ask ourselves, in the wake of Del Monte, what provisions would I add to best protect my client against the ramifications of Vice Chancellor Laster’s ruling? This can often lead to creative solutions, and I am aware of at least two merger agreements—I am sure there are also variations on this theme—where the acquirer has successfully negotiated for:
(1)an express statement that if there is an injunction that would require the target to breach the no-shop or otherwise limits the rights of the acquirer under the no-shop and matching rights provisions, the acquirer can terminate the agreement;
(2)an express statement that if there is an injunction that would eliminate or reduce the acquirer’s right to a termination fee, the acquirer can nevertheless terminate the agreement; and
(3)an exception to the severability provisions that attempts to neuter the ability of a court to hold the no-shop, match rights or termination fee provisions unenforceable without triggering a termination right for the acquirer.23
A reasonable target response to such a request from an acquirer would be to note that undergirding the injunctive relief granted in Del Monte was the involvement of the private equity firm acquirer in the financial advisor’s misconduct. As the court noted, the relief it granted served to deprive the acquirer “temporarily of the advantages it obtained by securing a deal through collusion” with the target’s financial advisor.24 If an acquirer wants to avoid a similar fate, it should simply forego colluding with the financial advisor. The acquirer’s response undoubtedly would be that the obligation to control the activities of the target’s financial advisor rests, as Del Monte holds, with the company’s board, and that it should not be the acquirer’s responsibility to ascertain whether the target’s financial advisor is crossing the line or simply engaging in a well thought-out negotiation strategy. It will be interesting to see whether these provisions become more prevalent in the coming months.
Financial advisors perform a vital role in helping their clients fully and properly evaluate potential transactions. However, given the nature of their business, conflicts of interest—created by fee structures, relationships and other opportunities—are common. Company boards and their attorneys, therefore, need to be sensitive to and vigilant about discerning potential conflicts of interest to allow them to properly evaluate the advice of the financial advisor, to make appropriate disclosures, and to avoid providing plaintiffs with useful ammunition to seek recovery or delay.
Mr. Gill is a partner in the M&A practice group of Vinson & Elkins L.L.P. and concentrates his practice on mergers and acquisitions, corporate finance and securities, and corporate governance. He has successfully represented public and private companies as well as private equity firms and investment banking firms. Mr. Gill has worked with clients in diverse industries, including energy and oil field services, finance, chemicals, telecommunications, and technology and software. Mr. Gill would like to thank his many colleagues at Vinson & Elkins for their thoughtful review, and Kelly Sanderson for her contributions to this article.
© 2011 Vinson & Elkins L.L.P.
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