What is the Appropriate Standard of Review for Deal Protection Measures?

From The Corporate Governance Advisor, Vol.8:4, July/August 2000
Copyright ©2000 Aspen Law & Business, a Division of Aspen Publishers, Inc.
A Wolters Kluwer Company.
Reprinted with permission. All rights reserved.

In the past year, numerous decisions by the Delaware Court of Chancery have prompted a renewed focus on the fiduciary responsibilities of corporate directors when approving various deal protection measures in the merger context.[1]  Although a number of commentators have speculated on some of the ramifications of those decisions for deal protection measures, scant commentary has been offered on a threshold issue that was raised (and resolved with differing results) by several of the decisions:  What standard of judicial review is applicable in the event that a stockholder challenges deal protection devices such as no-solicitation/no-talk clauses, termination fees, and stock option agreements?[2]

The Current Split of Authority

The Court of Chancery addressed this issue most recently in McMillan v. Intercargo Corp.,[3] a case involving the acquisition of Intercargo by XL America for $12 per share.  The plaintiffs alleged, among other things, that the directors had not satisfied their so-called Revlon duties[4] to obtain the best price reasonably available and that the termination fee set forth in the merger agreement was both preclusive and coercive.[5]  In the course of granting the defendants' motion for judgment on the pleadings,[6] Vice Chancellor Strine expressed his view that deal protection devices, to the extent they look and function like defensive measures (such as poison pills) should be subject to the Unocal[7] enhanced scrutiny standard of judicial review.[8]  In a revealing footnote, Vice Chancellor Strine observed:

Under a "duck" approach to the law, "deal protection" terms self-evidently designed to deter and make more expensive alternative transactions would be considered defensive and reviewed under the [Unocal] standard.  The word "protect" bears a close relationship to the word "from."  Provisions of this obviously defensive nature (e.g., no-shops, no-talks, termination fees triggered by the consummation of an alternative transaction, and stock options with the primary purpose of destroying pooling treatment for other bidders) primarily "protect" the deal and the parties thereto from the possibility that a rival transaction will displace the deal.  Such deal protection provisions accomplish this purpose by making it more difficult and expensive to consummate a competing transaction and by providing compensation tot he odd company out if such an alternative deal nonetheless occurs.  Of course, the mere fact that the court calls a "duck" a "duck" does not mean that such defensive provisions will not be upheld so long as they are not draconian.[9]

Although one may be tempted to read Vice Chancellor Strine's comments in Intercargo narrowly because the case involved a change of control, it is worth noting that he articulated the same view last fall in a case involving a strategic, non-change-of-control merger.  In that case, Ace Ltd. v. Capital Re Corp.,[10] Capital Re initially agreed to merge with Ace in a stock-for-stock merger.  The parties entered into a merger agreement that included a host of deal protection devices, including a "no-talk" provision.  When Capital Re sought to terminate the merger agreement in favor of an alternative deal, Ace sought to enjoin the termination, arguing that Capital Re had violated the "no-talk" provision.  Vice Chancellor Strine ultimately concluded that Capital Re not violated the "no-talk" provision as he interpreted it.  In doing so, he expressed the view that "when corporate boards assent to provisions in merger agreements that have the primary purpose of acting as a defensive barrier to other transactions not sought out by the board, some of the policy concerns that animate the Unocal standard of review might be implicated."[11]

Only two days after the release of Vice Chancellor Strine's opinion in Ace, Vice Chancellor Steele weighed in with his own approach to the standard of review question in In re IXC Communications, Inc. Shareholders Litigation.[12]  In IXC, the plaintiff stockholders sought to preliminarily enjoin the pending stockholder vote on a proposed merger of IXC with Cincinnati Bell, Inc., as well as certain provisions of the merger agreement. Rejecting plaintiffs' challenges to the termination fee, stock options, and no-shop clause, Vice Chancellor Steele held that the business judgment rule, not enhanced judicial scrutiny under Unocal, was applicable because those deal protection devices were not defensive mechanisms instituted in response to a perceived threat from a potential acquiror making a competing bid.[13]  More recently, Vice Chancellor Steele reiterated that holding in State of Wisconsin Investment Board v. Bartlett.[14]

Vice Chancellors Strine and Steele have approached the standard of review issue from different perspectives.  Vice Chancellor Steele's approach seems to be more traditional and deferential, viewing the business judgment rule much like a default standard that applies in the absence of authority definitively holding that a different standard of review should be applicable in particular circumstances.  Accordingly, he held in IXC Communications and Bartlett that Unocal review was not applicable because the boards of directors in those cases assented on a "clear day" (i.e., when there was no known competing bidder) to the inclusion of deal protection devices in the context of strategic mergers.  Vice Chancellor Strine, on the other hand, appears to advocate Unocal review of deal protection measures whenever the primary purpose of those measures is to protect the deal by deterring alternative transactions.  In Vice Chancellor Strine's view, the Unocal standard of review may be applicable to deal protection measures regardless of whether a competing bidder is known at the Time the board approves a merger agreement and regardless of whether the deal is a strategic one or one contemplating a change of control.

A Return To The Time Decision?

Although neither Vice Chancellor Strine nor Vice Chancellor Steele has cited the Court of Chancery's decision in Paramount Communications Inc. v. Time Inc.,[15] in support of his position of his position on the issue of the appropriate standard of review for deal protection devices, each position finds some support in that decision.  In Time, Time Inc. and Warner Communications Inc. initially agreed to a strategic merger involving those companies in which the holders of Warner common stock would receive common stock of Time.  The merger agreement included a no-shop clause.  In addition, the parties entered into a share exchange agreement that gave each party the option to trigger an exchange of shares under certain circumstances. Management of Time also obtained "dry-up" agreements from various banks promising not to finance any attempt to take over Time.  Shortly after Time and Warner agreed to merge, Paramount mounted a late effort to derail the proposed transaction in favor of its own cash bid for Time.  In response to Paramount's bid, Time and Warner agreed to restructure their proposed transaction to provide for an initial tender offer by Time for 51 percent of Warner, followed by a merger.

In its suit to enjoin the Time-Warner merger, Paramount argued, among other things, that enhanced scrutiny under Unocal was the appropriate standard of review for evaluating the decision of the Time directors to enter into the restructured transaction with Warner.  Time, in response, argued that judicial review of the revised transaction should involve "the same business judgment form of review as would have been utilized in a challenge to the authorization of the original merger agreement."[16]  Rejecting Time's argument, the Court of Chancery concluded that the Unocal "form of review applies, at the least, to all actions taken after a hostile takeover attempt has emerged that are found to be defensive in nature."[17]  The court amplified this point in a footnote by adding:

When I say at the least, I refer to the fact that the Unocal form of analysis will also be utilized when a preemptive defensive measure is deployed, where the principal purpose of the action (and not simply a collateral, practical effect) is defensive in a change of control sense.[18]

Ultimately, the court concluded that Time's response was reasonable in relation to the specific threat posed to the Warner merger by the Paramount offer.

A close reading of the Court of Chancery's opinion in Time with respect to the circumstances in which Unocal review is appropriate would appear to offer support for a proponent of Vice Chancellor Strine's position.  Specifically, where a corporation agrees on a "clear day" to include a "preemptive" deal protection device, the principal purpose of which is defensive in nature, the Court of Chancery's decision in Time can be read to suggest that the appropriate standard of review should be Unocal.

The rationale underlying Unocal is not necessarily applicable with respect to all mergers.

On the other hand, the Court of Chancery's Time decision expressly held only that Unocal was the appropriate standard of review for evaluating Time's defensive response (i.e., the decision to restructure the original transaction).  The Court did not address whether the original deal protection devices, which included the no-shop clause, the share exchange agreement, and the dry-up agreements, would have been subject to review under Unocal.  In fact, a proponent of Vice Chancellor Steele's position could argue that the Court of Chancery's opinion in Time appears to suggest that the business judgment rule attached to Time's original decision to approve a merger transaction that include deal protection measures.[19]

Grappling with Other Existing Precedent

One analytical obstacle to applying Unocal review to all deal protection devices in the merger context (Vice Chancellor Strine's approach) is that the rationale underlying Unocal is not necessarily applicable with respect to all mergers.  Enhanced scrutiny is required under Unocal when a board has implemented defensive measures in response to a threat to its control over corporate policy and effectiveness.  The Delaware courts justify application of enhanced scrutiny as a "threshold" level of analysis[20] in such circumstances because of the "omnipresent specter" that directors may be acting primarily out of their own interest to retain the powers and perquisites of their office, rather than in the best interests of the corporation and its stockholders.[21]  If a merger agreement contemplates that a majority of one constituent corporation's board of directors will not serve as directors of the surviving corporation, the articulated rationale underlying Unocal enhanced scrutiny review does not apply to deal protection provisions approved by that board, for such provisions cannot have been motivated by the desire of a majority of the board to retain office.[22]  In that respect, a "duck" approach applying enhanced scrutiny to deal protection measures in one context just because those measures look (facially) like the deal protection measures to which the court applies scrutiny in a quite different context does not provide an entirely satisfying rationale for extending the reach of Unocal.

That is not to say, of course, that application of Unocal-type enhanced scrutiny to all deal protection measures might not be justifiable on some other basis.  Indeed, in his Ace opinion, Vice Chancellor Strine may have sewn the seeds of a rationale for so extending Unocal.  The Vice Chancellor not only noted that deal protection devices might implicate "some of the policy concerns that animate the Unocal standard of review," but also emphasized throughout the opinion the "special importance" of the fiduciary duties of care and loyalty in circumstances in which a board of directors is making a decision concerning stockholder ownership rights, in contrast to an "enterprise" decision, such as what product to manufacture.[23]

Vice Chancellor Steele's approach also arguably involves some analytical leaps of faith. In IXC, Vice Chancellor Steele cited the Delaware Supreme Court's decision in In re Santa Fe Pacific Shareholders Litigation[24] in support of the proposition that Unocal enhanced scrutiny review applies to deal protection measures in merger agreements only if there exists a perceived threat from a known competing bidder at the Time the merger agreement is approved.[25]  Santa Fe Pacific, however, involved a strategic merger between Santa Fe Pacific and Burlington Northern, Inc. in connection with which the companies had implemented a number of defensive measure (e.g., a poison pill and a joint tender offer) and deal protection measures ( a termination fee) in response to competing offers for Santa Fe Pacific from Union Pacific Corporation.  The Supreme Court held that Unocal enhanced judicial scrutiny was applicable to the shareholder plaintiffs' challenges to those measures.[26]  The Supreme Court, however, did not address whether Unocal or the business judgment rule should properly apply if defensive and deal protection measures are implemented in connection with a strategic merger at a Time when no competing bidder is on the scene.

A board is best advised to assume that its decision to adopt deal protection provisions may be reviewed under the Unocal standard.

With respect to defensive measures more generally, it is well settled that Unocal is the appropriate standard of review when a board of directors implements such measures (such as a poison pill or advance notice bylaw) on a "clear day" in response to the general market threat of inadequate and coercive acquisition offers.[27]  Even Vice Chancellor Steele appears to agree that Unocal review is applicable to deal protection provisions if they are approved at a Time when there is a known competing bidder.  It does not necessarily follow, however, that the Unocal standard is inapplicable if the same type of deal protection measures are adopted on a "clear day."  Regardless of whether a competing bidder has made itself known at or prior to the Time a board approves deal protection devices in connection with a merger, such devices are nearly always designed to protect the merger from potential future competing transactions.  That is a point that Vice Chancellor Strine stressed in his "duck" footnote in Intercargo.

Thus, although both Vice Chancellor Strine's and Vice Chancellor Steele's approaches find some support in existing case law (most notably, Time), neither approach is necessarily compelled by existing precedent. Definitive resolution of the issue, therefore, likely will require guidance from the Delaware Supreme Court.  That Court will need to decide the threshold policy question whether to extend Unocal-type review beyond situations involving an "omnipresent specter" of director entrenchment (Vice Chancellor Strine's approach) or whether the business judgment rule and the principles of deference attendant thereto should govern situations in which deal protection measures are adopted on a "clear day" (Vice Chancellor Steele's approach).  If the Court chooses the latter course, it also will need to articulate a rationale for why such "protective" measures should be considered under a different standard of review than defensive" measures more generally.

The alternatives posed by Vice Chancellors Strine and Steele, of course, may not represent the only possible resolutions of the debate.  Perhaps the Delaware courts ultimately will determine that Unocal-type review is neither applicable to deal protection measures in all circumstances nor inapplicable merely because such measures were implemented at a Time when there was no known competing bidder.  In keeping with the rationale underlying Unocal itself, the Delaware courts eventually may conclude that the applicable standard of review should turn on whether the particular circumstances give rise to the "omnipresent specter" that a majority of the board may be acting out of a desire to retain office rather than in the best interests of the corporation and its stockholders.  At least in the context of mergers not involving a change of control,[28] a somewhat compelling argument can be made that if a majority of a board of directors will continue on the board of the surviving corporation, any deal protection measures approved by such a board should be reviewed under Unocal.  But if a majority of directors will not serve on the board of the surviving corporation, perhaps the business judgment rule should apply and the courts should defer to the board's decision to implement deal protection measures.

Advising the Board

The debate concerning the appropriate standard of review that Delaware courts should apply to deal protection measures in the merger context where no competing bidder is present at the Time those measures are implemented is likely to continue.  Although this debate is academically interesting, its existence also presents a practical dilemma for counsel advising boards of directors considering merger transactions.  For the present, a board is best advised to assume that its decision to adopt deal protection provisions (meaning provisions that have the primary purpose of protecting a transaction from the possibility of a rival transaction displacing the deal) may be reviewed under the Unocal standard, or principles akin to Unocal.  Accordingly, the board approval process should include careful consideration of the potential impacts of, and alternatives to, the particular provisions under consideration.  The board also should seek to ensure that those provisions do not preclude other potential bidders from at least expressing an interest in pursuing an alternative transaction with the corporation, and that such provisions do not coerce stockholders into voting in favor of the proposed merger for reasons unrelated to its merits.

Conclusion

The eventual outcome of the current debate may be affected by the recent confirmation of Vice Chancellor Steele as a member of the Delaware Supreme Court.  As a Justice of the Supreme Court, he may not be presented so frequently with the opportunity to express and develop his views on the issues discussed herein.  Indeed, because relatively few decisions of the Court of Chancery are appealed to the Delaware Supreme Court, Vice Chancellor Strine and the remaining members of the Court of Chancery are likely to have far more opportunities to carry forward the debate about the proper standard of review applicable to deal protection measures generally.  It remains to be seen whether, given the opportunity in the appellate context to address the appropriate standard of review for deal protection measures, soon-to-be Justice Steele would be able to convince his Supreme Court colleagues that his deferential approach to the issue is more appropriate than the "duck" approach advocated by Vice Chancellor Strine.

Notes

*  Mark A. Morton, John F. Grossbauer, and Michael A. Pittenger are partners at Potter Anderson & Corroon LLP in Wilmington, DE.   The views expressed herein are those of the authors and may not be representative of the views of the firm or its clients.

[1] See, e.g., McMillan v. Intercargo Corp., C.A. No. 16963, Strine, V.C. (Del. Ch. Apr. 20, 2000); State of Wisconsin Investment Board v. Bartlett, C.A. No. 17727, Steele, V.C. (Del. Ch. Feb. 24, 2000); In re IXC Comm., Inc. Shareholders Litig., C.A. Nos. 17324, 17334, Steele, V.C. (Del. Ch. Oct. 27, 1999); Ace Ltd. v. Capital Re Corp., 747 A.2d 95, 108 (Del. Ch. 1999); Phelps Dodge Corp. v. Cyprus Minerals Co./Asarco Inc., C.A. No. 17398, Chandler, C. (Del. Ch. Sept. 27, 1999) (Bench Ruling).

[2] Compare Intercargo, id. and Ace Ltd., 747 A.2d at 108 with In re IXC Comm., id. and State of Wisconsin Investment Board, id.

[3] C.A. No. 16963, Strine, V.C. (Del. Ch. Apr. 20, 2000).

[4] See Revlon, Inc., v. McAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).

[5] The termination fee in question (excluding expenses) amounted to approximately 3.5 percent of the deal value.

[6] In granting the motion for judgment on the pleadings, Vice Chancellor Strine held that the plaintiffs had not sufficiently pleaded facts supporting a claim for breach of the duty of loyalty and that the claims against the directors for monetary damages for breach of the duty of care were barred by an exculpatory charter provision authorized by Section 102(b)(7) of the Delaware General Corporation Law.  Intercargo, supra note 1, Mem. Op. at 16-17, 30.

[7] Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).

[8] See Unitrin, Inc. v. American General Corp., 651 A.2d 1361, 1372 n.9 (Del. 1995) (noting that enhanced scrutiny review under Unocal applies "whenever the record reflects that a board of directors took defensive measures in response to a perceived threat to corporate policy and effectiveness which touches upon issues of control'")(quoting Stroud v. Grace, 606 A.2d 75, 82 (Del. 1992) and Gilbert v. El Paso Co., 575 A.2d 1131, 1144 (Del. 1990)).  In contrast to judicial review under the business judgment rule, which affords great deference to business judgments of directors, enhanced judicial scrutiny under Unocal allows a court to engage in a threshold examination of the substantive reasonableness of board decisions.  See In re Gaylord Container Corp. Shareholder Litig., C.A. No. 14616, Strine, V.C. (Del. Ch. Jan 26, 2000), Mem. Op at 27.

[9] Intercargo, supra note 1, Mem. Op. at 29 n.62 (emphasis in original).  The Vice Chancellor observed that the termination fee and no-shop provisions at issue in Intercargo were "rather ordinary," although he characterized the 3.5 percent break up fee as being "at the high end of what our courts have approved."  Id., Mem. Op. at 27.

[10] 747 A.2d 95 (Del. Ch. 1999).

[11] Id. at 108.

[12] C.A. No. 17334, Steele, V.C. (Del. Ch. Oct. 27, 1999).

[13] In re IXC, supra note 1, Mem. Op. at 23 (citing In re Santa Fe Pacific Shareholders Litig., 669 A.2d 59, 71 (Del. 1995)).

[14] C.A. No. 17727, Steele, V.C. (Del. Ch. Feb. 24, 2000).

[15] C.A. Nos. 10670, 10866, 1989 WL 79880, Allen, C. (Del. Ch. July 14, 1989), aff'd, 571 A.2d 1140 (Del. 1989).

[16] Id., 1989 WL 79880, at *27

[17] Id. (emphasis added).

[18] Id., 1989 WL 79880, at *27, n.21 (emphasis added).

[19] See id., 1989 WL 79880, at *27 ("Powerful circumstances in this case include the fact that the original Time-Warner agreement was, or appears at this stage to have been, chiefly motivated by strategic business concerns; that it was an arm's-length transaction; and, that while its likely effect on reducing vulnerability to unsolicited takeovers may not have been an altogether collateral fact, such effect does not appear to be predominating").  On appeal, the Delaware Supreme Court affirmed the Court of Chancery's decision in Time, but may have misread the trial court opinion, suggesting that the Chancellor had concluded that Unocal review applied to the deal protection provisions of the original merger agreement.  In referring to the lock-up agreement, no-shop clause, and "dry-up" agreements that were implemented in connection with the original merger agreement, the Supreme Court stated "as the Chancellor said, such devices are properly subject to a Unocal analysis."  Time, 571 A.2d at 1151.  The Supreme Court further noted that "Unocal alone applies to determine whether the business judgment rule attaches to the revised merger agreement."  Id.  Although the Chancellor clearly reached the latter conclusion, his opinion did not squarely address whether Unocal would have been the appropriate standard for evaluating the deal protection devices that were associated with the original transaction.  As noted, the decision arguably could be read to suggest that the business judgment rule might have been applicable with respect to those devices.

[20] In Gaylord Container, Vice Chancellor Strine questioned the continuing utility of characterizing Unocal as a "threshold" standard for determining whether the business judgment rule or the entire fairness standard of review should apply to particular board decisions.  He observed that, as a practical matter, subsequent review under either of those standards will rarely, if ever, yield a conclusion different than that reached under the threshold Unocal analysis.  Gaylord Container, supra note 8, Mem. Op. at 26-33.

[21] Kahn v. Roberts, 679 A.2d 460 (Del. 1996); Unocal, 493 A.2d at 954; Gaylord Container, supra note 21, Mem. Op. at 27.

[22] See Hills Stores Co. v. Bozic, C.A. Nos. 14527, 14460, 14787, Strine, V.C. (Del. Ch. Feb. 22, 2000), Mem. Op. at 38 (noting that in applying Unocal standard, a court considers whether a majority of the board of directors has an "interest" in the sense of a motivation to secure continuation of the incumbent board's control over the corporation).

[23] Ace, 747 A.2d at 105, 108-109.

[24] 669 A.2d 59 (Del. 1995).

[25] See IXC, supra note 1, Mem. Op. at 23 (citing Santa Fe Pacific, 669 A.2d at 71).

[26] Santa Fe Pacific, 669 A.2d at 71-72.

[27] See, e.g., Unitrin, 651 A.2d at 1388; Moran v. Household Int'l, Inc., 500 A.2d 1346, 1350 (Del. 1985); Gaylord Container, supra note 8, Mem. Op. at 26-27, 34-35.

[28] In the context of mergers involving changes of control, existing precedent mandates that deal protection measures be reviewed under a slightly different form of enhanced scrutiny review in accordance with Revlon, Inc., supra note 4, and its progeny.  One benefit of Vice Chancellor Strine's approach would be the consistency of having one standard of review Unocal-like enhanced scrutiny apply to deal protection measures in all contexts, in contrast to the existing state of the law in which one of three standards of review (the business judgment rule, Unocal, or Revlon) might be applicable depending on the specific facts and circumstances.