A Discussion of the Recent Amendments to Section 251 of The Delaware General Corporation Law

Last year, the Governor of the State of Delaware signed into law a bill, effective July 1, 1998, that amended the General Corporation Law of the State of Delaware [2](the "DGCL"), in order to effect a number of housekeeping measures and several substantive changes.  In the months since those amendments became effective, two amendments to Section 251 of the DGCL, relating to board approval of merger agreements, have generated the most discussion among corporate practitioners (the "Section 251 Amendments").  The discussion that follows first summarizes the Section 251 Amendments and then examines the historical developments that prompted them. Next, we discuss the issues that counsel should consider when advising either a target[3] or an acquiror whether to agree to include provisions authorized by the recent amendments in a proposed merger agreement.  Finally, we examine how the inclusion of such provisions in a merger agreement may impact the negotiation of a number of related covenants in such an agreement.

A. Section 251 Amendments

The Section 251 Amendments resulted in two specific changes. First, Section 251(b) was amended to require that the board of directors adopt a resolution approving the merger agreement and declaring the merger agreement to be "advisable."  Prior to such amendment, Section 251 required a board of directors to "adopt" a resolution approving a proposed merger agreement and to "submit[]" the merger agreement to the stockholders for their approval at an annual or special meeting.  Section 251, however, did not expressly require that the board "recommend" or "declare advisable" the proposed merger [4].  By contrast, Section 242 of the DGCL, which governs amendments to certificates of incorporation, has long required that a board of directors adopt a resolution setting forth a proposed amendment and "declaring its advisability." [5]

The official legislative synopsis to the amendment to Section 251(b) provides that:

The amendment to subsection (b) of Section 251 requiring a determination by the board of directors that a merger agreement is advisable conforms the board approval requirement in that subsection to the requirement in subsection (b)(1) of Section 242 that the board of directors declare a charter amendment advisable prior to submitting it to stockholders.[6]

Second, the Section 251 Amendments added the following sentence to subsection (c):

The terms of the [merger] agreement may require that the agreement be submitted to the stockholders whether or not the board of directors determines at any time subsequent to declaring its advisability that the agreement is no longer advisable and recommends that the stockholders reject it.[7]

According to the official legislative synopsis to the amendment to Section 251(c):

... a merger agreement may require that it be submitted to the stockholders even if the board, subsequent to its initial approval thereof, determines that the agreement is no longer advisable and recommends that the stockholders reject it. Compare Smith v. Van Gorkom, 488 A.2d 858, 887-88 (Del. Supr. 1985).  The amendments are not intended to address the question whether such a submission requirement is appropriate in any particular set of factual circumstances.[8]

B. Historical Background

In many respects, the impetus for the Section 251 Amendments may be traced to the Delaware Supreme Court's decision more than a decade ago in Smith v. Van Gorkom.[9]  The Van Gorkom decision is, of course, best known for the Court's holding that the directors of Trans Union Corporation were personally liable for failing to exercise due care in considering and approving an arm's length cash-out merger.  However, the Court’s decision also includes a discussion concerning a board’s ability to withdraw its recommendation of a proposed merger and the possible consequences of such a decision:

[T]he [target] board could not remain committed to the Pritzker merger and yet recommend that its stockholders vote it down; nor could it take a neutral position and delegate to the stockholders the unadvised decision as to whether to accept or reject the merger.  Under 251(b), the board had but two options: (1) to proceed with the merger and the stockholder meeting, with the Board’s recommendation of approval; or (2) to rescind its agreement with Pritzker, withdraw its approval of the merger, and notify its stockholders that the proposed shareholder meeting was cancelled...  But the second course of action would have clearly involved a substantial risk – that the Board would be faced with a suit by Pritzker for breach of contract...  [Under the merger agreement], the Board's only ground for release from its agreement with Pritzker was its entry into a more favorable definitive agreement to sell the Company to a third party.[10]

Several important principles are suggested by the Court’s observations in Van Gorkom.  First, notwithstanding the absence of a recommendation requirement in Section 251, the Court clearly suggested that Section 251 required the board to recommend approval of the proposed merger agreement.  Second, Van Gorkom suggests that, without the board’s recommendation of a proposed merger, the stockholders’ meeting must be cancelled because the stockholders are not entitled to consider the proposed merger.  Third, the decision suggests that if a board withdraws its approval of a proposed merger agreement, then the board also must rescind the agreement and, unless it has preserved an express right to terminate the agreement under such circumstances, the board may be faced with a possible suit for breach of contract.  Fourth, the Court indicated that the target board, if it wants to avoid unnecessary exposure to claims relating to fiduciary and/or contractual breaches, should seek to have included in the merger agreement specific "releases" or "outs" that provide the board with the flexibility to withdraw its recommendation and terminate a merger agreement under certain limited circumstances.

For over a decade, corporate practitioners debated the ramifications of Van Gorkom.  On the one hand, some practitioners argued that the members of a board of directors have a fiduciary right and obligation, at any point prior to stockholder approval, to change their recommendation of a merger agreement if it is no longer in the best interests of the stockholders (even though Van Gorkom suggested that the board’s revocation would expose it to a breach of contract claim absent an appropriate contractual termination right).  On the other hand, other practitioners read Van Gorkom to suggest that a board’s duties, including its obligation to recommend a merger proposal, is completely satisfied at the time of the board’s initial approval of the transaction, and, unless the merger agreement otherwise provides, the board does not have the right (or the duty) to rescind its recommendation at a later date.

Under either reading of Van Gorkom, however, the target's board of directors has a strong incentive to negotiate for appropriate "outs" that enable the board to consider and respond to a subsequent, superior offer.  Without such protections, a target board may risk finding itself in the unenviable position of either (i) continuing to "recommend" an initial merger proposal, even though the board believes a subsequent, superior offer is in the best interests of the stockholders, or (ii) withdrawing its recommendation, canceling the stockholders’ meeting, and rescinding the initial merger agreement.  In the former case, the target board’s decision would raise, at best, troubling disclosure issues and, at worst, may give rise to breach of fiduciary duty claims (based, for example, upon the board’s failure to negotiate for appropriate contractual flexibility in the merger agreement).  In the latter case, the target board’s decision may lead to a breach of contract claim seeking either specific performance of the merger agreement or damages.

Recognizing that a board may be faced with a variety of circumstances where it may wish to rescind its initial recommendation without facing a claim for specific performance of the agreement or contractual damages, counsel for targets have, over the years, continued to negotiate for the inclusion of specific "fiduciary outs" in merger agreements.  Typically, such fiduciary outs provide a target board with the right to respond to certain types of unsolicited offers, withdraw its recommendation in favor of subsequent deals satisfying specific criteria, and terminate the merger agreement under certain limited circumstances.

More recently, however, some corporate practitioners have argued that, so long as the board of directors has complied with its fiduciary duties when initially approving a merger proposal, then the board does not have the obligation, as a fiduciary matter, to reserve the right to later withdraw its recommendation.  Under this theory, there is no continuing duty to re-evaluate a merger proposal in view of changed circumstances occurring prior to the shareholder vote.  Rather, such practitioners maintain, if a target board wants the right to withdraw its recommendation and consider subsequent offers, then the board must negotiate to create that right as a matter of contract.

The Section 251 Amendments would appear to have resolved several of the issues raised (but not resolved) by Van Gorkom.  First, as revised, Section 251(b) has clarified that the board of directors must declare the merger agreement to be "advisable" prior to submitting it to the stockholders.  Second, if the target and acquiror agree to include a Section 251(c) provision in the merger agreement, then Section 251(c) effectively overrules the suggestion in Van Gorkom that stockholders may not consider a merger proposal without the board’s recommendation in place.

The availability of Section 251(c) also addresses some of the concerns that have been raised in recent years by corporate practitioners.  On the one hand, for those practitioners who expressed the belief that the target board had a continuing obligation to consider the advisability of a proposed merger transaction until the stockholders had approved the transaction, the inclusion of a Section 251(c) provision now permits the target to avoid the possibility of contractual damages arising from a board’s withdrawal of its recommendation.  On the other hand, for those practitioners who have argued that a target board that satisfied its fiduciary duties when initially recommending a merger agreement has no fiduciary duty to reserve the right to recommend a later, superior proposal, the use of a Section 251(c) provision merely provides acquirors with a means by which they will be assured of presenting a binding agreement to the target’s stockholders for their consideration.

Not surprisingly, the Section 251 Amendments also have raised a number of new questions.  The agreement of the target and acquiror to include a Section 251(c) provision in a merger agreement, however, also gives rise to a number of issues, including (i) whether a board is required by its fiduciary duties to continue to evaluate the advisability of a merger proposal until such time as the stockholders have acted on such proposal, (ii) whether the fiduciary duties of the board of directors ever will require the board to withdraw its recommendation of a merger proposal, (iii) what measures, if any, a board of directors should (or must) take after it has withdrawn its recommendation in order to preserve the corporation’s ability to pursue an alternative transaction that the board has determined will better advance the interest of stockholders, and (iv) whether, after a target board has withdrawn its recommendation, an acquiror may nonetheless require a target to undertake measures in support of the merger proposal (for example, requiring target to abide by its covenant to solicit proxies in favor of the merger).

C. Considerations When Negotiating A Section 251(c) Provision

In most cases, the inclusion of a Section 251(c) provision in a merger agreement will affect the rights and duties of both the target and the acquiror.  For that reason, the boards of both the target and the acquiror should carefully weigh whether such a provision is appropriate in the context of the proposed merger agreement.  In practice, however, it is likely that Section 251(c) provisions ordinarily will be regarded as pro-acquiror provisions.  For that reason, a target board should exercise particular caution when considering whether and under what circumstances to agree to include a Section 251(c) provision.  In the discussion that follows, we have identified a number of the issues to be considered by a target and an acquiror in negotiations concerning a proposed Section 251(c) provision.

1. Continuing Duty to Recommend?

A number of Delaware corporate practitioners have suggested that Section 251(c), when used, may require a target board to continue to consider whether a merger agreement remains advisable until such time as the stockholders have acted on the merger agreement.  In reaching this conclusion, those practitioners have observed that, if the board of directors has the right to withdraw its recommendation (whether or not it is obligated to proceed with a meeting of stockholders), then presumably the board’s decision to withdraw its recommendation or to continue to recommend the merger must be an informed one.  In order to render an informed judgment, however, the board of directors arguably would have to monitor and assess the advisability of the proposed transaction up to the time of the stockholder vote.  Moreover, if the target board’s duty to recommend the proposed merger agreement could be satisfied merely by its initial recommendation, with no further duty to evaluate the advisability of the transaction (as some practitioners have suggested), then arguably the reference in Section 251(c) to the board’s ability to determine "that the agreement is no longer advisable and recommend[] that the stockholders reject it"[11] could be viewed as meaningless.  Since a Delaware court will endeavor to find meaning in all of the terms set forth in a statutory provision,[12] a Delaware Court could conclude that, when the parties have agreed to be bound by Section 251(c), the target board has a continuous (not merely an initial) obligation to consider its recommendation of a proposed merger agreement.  One would expect, however, that such a duty would arise only if a subsequent change in circumstances called into question the board’s initial decision to recommend the transaction.

2. Impact of Standstill Agreements

Prior to commencing serious discussions concerning a proposed acquisition, many targets will require a potential acquiror to enter into a standstill agreement.  Typically, such agreements require, among other things, that the acquiror may not obtain direct or beneficial ownership of any additional shares of the target without the approval of the target board.  However, if a standstill agreement permits an acquiror to enter into voting agreements with other stockholders (and thus lock up the vote of a majority or substantial portion of the target’s outstanding voting stock), then the existence of a Section 251(c) provision in the merger agreement may enable the acquiror to take steps to guarantee the approval of the proposed merger agreement.  For example, if the acquiror is able to enter into voting agreements with the holders of a majority of target’s outstanding shares pursuant to which they agree to vote their shares in favor of the proposed merger agreement, then the target board’s ability to withdraw its recommendation may be rendered meaningless.  For that reason, in some circumstances, it may be important for a target board to negotiate for a more traditional termination right that preserves its ability to pursue subsequent proposals offering higher value to stockholders.  Indeed, in certain circumstances (such as a change of control context), one could argue that a decision by a board to agree to a Section 251(c) provision amounts to a breach of the board’s fiduciary duties if the acquiror has locked-up the vote (or is likely to do so).

3. Impact on Standard Merger Agreement Covenants

Where a target has agreed to include a Section 251(c) provision in a proposed merger agreement, the target’s subsequent decision to rescind its recommendation may present a myriad of potential problems for the target unless its counsel has successfully negotiated for certain limitations or carve outs to covenants that might later impose obligations on the target board that are inconsistent with its decision to withdraw its recommendation of the transaction.  For example, targets frequently covenant to solicit proxies in favor of a proposed merger agreement.  However, once a target board has withdrawn its recommendation of a merger agreement, it would be placed in a rather precarious position if it were at the same time contractually obligated to employ the target’s money and resources to solicit proxies in favor of that transaction.  Indeed, under such circumstances, one could argue the target board should have a duty to solicit proxies against the proposed merger agreement.  Many of the merger agreements that have been negotiated in the wake of the Section 251 Amendments, however, have not expressly conditioned the target board’s contractual obligation to solicit proxies in favor of the proposed transaction on the board’s continuing recommendation of the transaction.

Similarly, although Section 251(c) provides a mechanism for "requir[ing] that the [merger] agreement be submitted to the stockholders," Section 251 does not impose any special requirements with respect to the manner in which or time in which the stockholders’ meeting may or should be held.  As a result, an acquiror may demand that a merger agreement include a covenant requiring the target to hold the stockholders’ meeting on the earliest date available.  Conceivably, the acquiror also might request a covenant from the target that, at the request of the acquiror’s board, the target board will postpone the stockholders’ meeting for a specified period of time.  From the acquiror’s perspective, the former request permits the acquiror to minimize the period during which the target will have an opportunity to rescind its recommendation, while the latter request would enable the acquiror additional time, if necessary, to solicit proxies in favor of the proposed merger if the target board were to withdraw its recommendation.  By contrast, the target in most cases will want to negotiate for a covenant that grants the target board as much autonomy as possible with respect to the timing of the stockholders’ meeting.  With such autonomy, the target board will be in a position to schedule the stockholders’ meeting for a date when it believes the acquiror’s proposal is likely to be approved (if the board’s recommendation remains in place), or rejected (if the board has withdrawn its recommendation).

In addition to negotiating for flexibility with respect to those covenants that otherwise would require a target board to engage in conduct that might favor a merger proposal even after it has withdrawn its approval recommendation, a target board also should consider what limitations, if any, it will accept on its ability to support a different transaction in the event it later determines to withdraw its initial recommendation.  Frequently, an acquiror will seek to require a target board to agree that it will not recommend any other transaction, amend its poison pill (except to carve out the initial bidder), or approve any other person or transaction for purposes of Section 203 of the DGCL, the Delaware statute governing business combinations with interested stockholders.[13]  In light of the preclusive nature of such covenants, in some circumstances (such as those involving a proposed sale or change of control), the target board’s success or failure in negotiating "recommendation outs" to such covenants may be critical.  Unless the target board has negotiated appropriate "recommendation outs" for such covenants (and perhaps others), a new bidder’s only choice may be to make a bid, wait until the stockholders meeting, and hope that the stockholders vote to reject the initial transaction.

Of course, even if a target board has withdrawn its recommendation of a proposed merger agreement, a new bidder may be unwilling to await the outcome of the stockholders’ meeting.  It is worth noting, in this regard, that the Securities and Exchange Commission ("SEC") review period for mergers now typically takes nearly two months (plus additional time for the parties to respond to the SEC’s comments), after which period the target board usually needs additional time to notice and hold its stockholders’ meeting.  As a result, unless the target has negotiated appropriate outs, it is conceivable that a new bidder may have to wait three months or more before the target board could even consider recommending the new bid.

In light of such scenarios, target boards will no doubt seek to negotiate for limited "recommendation outs" that would permit, among other things, the target, in the event the board rescinds its recommendation, (i) to amend its poison pill to permit acquisitions by a later bidder, (ii) to approve, for purposes of Section 203 of the DGCL, either a business combination or the transaction by which a later bidder would become an "interested stockholder," and (iii) to recommend a new transaction.  Arguably, the failure to include such "recommendation outs" may unfairly deter other interested bidders.

4. Recommendation Outs

In light of the potential problems recited above, a prudent target board and its counsel should consider negotiating for "recommendation outs" to the aforementioned covenants, among others.[14]  In the event that the target board withdraws its recommendation, the target’s obligations under such covenants would be modified or omitted.  Thus, by way of example, the target and acquiror could qualify the target’s covenant to solicit proxies in favor of the merger agreement by providing that, if the target board shall have withdrawn its recommendation of the proposal, the target shall have the discretion to solicit proxies for or against the proposed merger.  Similarly, the target board should consider requesting comparable "recommendation outs" for its covenants with respect to its poison pill rights plan and Section 203 approval.

From the acquiror’s perspective, of course, such "recommendation outs" will be seen as undermining the stability of its proposed transaction and, therefore, will be resisted.  To the extent that the target's counsel is successful in convincing the acquiror’s counsel that the target board’s fiduciary duties require such "outs," the acquiror may be prepared to accommodate the target’s concerns.  In many situations, however, it is more likely that the acquiror would offer to condition the target board’s withdrawal of its recommendation (and, by extension, the "recommendation outs" to each of the aforementioned covenants) on the existence of a "superior proposal."

Targets may be expected to raise two objections to a "superior proposal out" provision.  First, as a threshold matter, a target may argue, for the reasons discussed above, that it is improper to impose any limitations upon the target board’s continuing obligation to consider whether to withdraw its recommendation of the proposed merger agreement.  Second, the target may wish to have the ability to withdraw its recommendation not only in response to superior offers, but also in other circumstances.  For example, the target may conclude that it is important for the board to have the ability to rescind its recommendation if (i) unforeseeable market events occur, (ii) the target experiences an unforeseen windfall, or (iii) the acquiror experiences an unforeseen shortfall.  Whether, and the extent to which, a target desires to maintain such flexibility will, of course, depend on the particular circumstances.

5. Disclosure Issues

If Section 251(c) is read as requiring a board to continue to consider the advisability of a proposed merger agreement until the stockholders have approved (or rejected) the proposal, then the target board may face difficult disclosure issues if it ultimately decides to withdraw its recommendation.  Specifically, if the target was unsuccessful in negotiating appropriate "recommendation outs," then the board may have a contractual obligation to undertake actions that are inconsistent with its decision to withdraw its recommendation.  Conversely, if the target fully discloses the basis for its decision to withdraw its recommendation, the board may risk a suit from the acquiror for its failure to use its best efforts to solicit proxies in favor of the merger proposal (assuming the merger agreement does not contain a "recommendation out" to such a best efforts covenant).  Obviously, the tensions created by what are arguably conflicting obligations may in many circumstances complicate the target’s effort to prepare and disseminate accurate proxy materials.

Even if the target board continues to recommend a proposed merger agreement, the nature of the board’s disclosure obligations may become quite muddled.  For example, if the merger agreement provides for a fixed exchange ratio, will dramatic market changes that depress (perhaps temporarily) the acquiror’s stock price require the target board to reconsider its recommendation?  If so, what information should the target board rely upon in reaching its new decision?  Should the target board request a bring down of its investment banker’s fairness opinion?  Assuming the target board concluded that the proposed merger remains "advisable," does the board have to amend its proxy materials to disclose that its recommendation has not changed?  These questions, and many others concerning Section 251(c), await the consideration of the Delaware courts.

6. Aggregate Effect

Finally, before agreeing to include a Section 251(c) provision in a proposed merger agreement, both the target and acquiror should considering the aggregate effect of all of the proposed "lock-up" provisions, including the Section 251(c) provision.[15]  As we noted above, a Section 251(c) provision has the potential to have a preclusive effect on a bidding process.  As a result, at least in the sale or change of control context, a target’s counsel is likely to argue that the target’s agreement to include such a provision would represent a significant concession and, therefore, that it should be met with comparable concessions from the acquiror.  Ultimately, however, since the target and acquiror both share the same goal – to structure an enforceable transaction that rewards the target’s stockholders with a fair price – and since the Delaware courts have not yet considered the impact of a Section 251(c) provision, targets and acquirors alike would be wise to use caution as the guiding principle when negotiating a proposed Section 251(c) provision.

D. Conclusion

The recent Section 251 Amendments may well have altered the legal landscape of Delaware corporate law more dramatically than many corporate practitioners expected or now appreciate.  Arguably, the inclusion of a Section 251(c) provision in a merger agreement imposes on the target board a fiduciary obligation to continue to consider whether to rescind its recommendation of the proposed merger agreement until such time as the stockholders have acted on the proposal.  In addition, when a Section 251(c) provision is used, counsel for both target and acquiror should consider the appropriateness of including many of the covenants typically contained in merger agreements, or at least the extent to which such typical covenants should be revised to include "recommendation out" provisions.

Notes:

1. Michael D. Goldman and Mark A. Morton are partners in the law firm of Potter Anderson & Corroon LLP, Wilmington, Delaware.  Gregory M. Johnson is an associate of that firm.  The authors also would like to acknowledge the assistance of Michael A. Pittenger, an associate of the firm, in preparing this article.  The views and opinions expressed herein are those of the authors and do not necessarily represent those of Potter Anderson & Corroon LLP or its clients.  Portions of this article have been, or may be, used in other materials published by the authors or their colleagues.

2. 8 Del. C. §101 et seq.

3. Solely as a matter of convenience, we have used the terms "target" and "acquiror" throughout this article.  Our use of such terminology, however, is not intended to suggest that the newly-enacted provisions of Section 251 are applicable only in the context of transactions involving a target and acquiror.  To the contrary, we recognize that under certain circumstances, such as a strategic merger, the merger may not have a true "acquiror" and, in light of that fact, the parties may agree to include a Section 251(c) provision in the merger agreement pursuant to which both parties agree to present the merger agreement to their stockholders.

4. Notwithstanding the silence of Section 251 on this point, most corporate practitioners routinely advised their clients to have their boards of directors approve proposed merger agreements and recommend them to the stockholders for their adoption.  Moreover, the Delaware Courts have suggested on several occasions that a board of directors is charged with the responsibility of recommending to stockholders approval of a proposed merger agreement.  See, e.g., Smith v. Van Gorkom, Del. Supr., 488 A.2d 858 (1985).

5. 8 Del. C. §242 (b)(1).

6. Ch. 39, L. ’98 Synopsis of Section 251.

7. Conforming changes also were made to Sections 252, 254, 257, 263 and 264 of the DGCL, each of which addresses a different form of merger.

8. Ch. 339, L. ’98 Synopsis of Section 251.

9. Del. Supr., 488 A.2d 858 (1985).

10. Id. at 888.

11. Section 251 (c) provides that a merger agreement may "require that the agreement be submitted to the stockholderswhether or not the board of directors determines at any time subsequent to declaring advisability that the agreement is no longer advisable and recommends that the stockholders reject it." (italics added)

12. See, e.g., Keeler v. Harford Mut. Ins. Co., Del. Supr., 672 A.2d 1012, 1016 (1996).

13. Under certain circumstances, the requirements of Section 203 may be inapplicable. 8 Del. C. §203(b)(6).  As a result, the target and acquiror may agree that a covenant relating to Section 203 of the DGCL is unnecessary.

14. The covenants discussed above by the authors are not intended to represent an exhaustive list of every covenant that might merit a "recommendation out."  To the contrary, depending upon the facts and circumstances of the particular case, it may (or may not) be appropriate to include such an "out" in some of the aforementioned covenants or in any number of other covenants.

15. See Paramount Communications v. QVC Network, Inc., Del. Supr., 637 A.2d 34 (1993).