Court of Chancery Provides Guidance on Top-Up Options
In a recent Delaware Court of Chancery decision, titled Olson v. ev3 Inc., Vice Chancellor J. Travis Laster granted an award of attorney fees and expenses of $1.1 million in connection with a contested fee application following approval of a settlement of a stockholder litigation. In doing so, Laster provided helpful guidance on a number of issues relating to top-up options, including the statutory prerequisites for the proper authorization of a top-up option under Delaware law.
According to Laster’s opinion, the underlying litigation related to a challenge to the acquisition of ev3 Inc. by Covidien Group S.a.r.l., pursuant to an agreement and plan of merger. The merger agreement provided for Covidien to acquire ev3 in a two-step transaction pursuant to which Covidien’s wholly owned subsidiary would first commence a tender offer to purchase ev3’s outstanding shares and then effect a prompt second-step merger in which all remaining ev3 stockholders would receive the same consideration.
The merger agreement included a top-up option, which Covidien’s wholly owned subsidiary could exercise if certain conditions were met. The court indicated that the top-up option was designed to permit Covidien’s wholly owned subsidiary to increase its stock ownership to at least 90 percent, the threshold needed to effect a short-form merger under Section 253 of the General Corporation Law of the State of Delaware (the DGCL).
Importantly, Laster noted the merger agreement provided that Covidien’s wholly owned subsidiary could pay for the top-up option shares in cash or by delivering a promissory note to ev3, with the promissory note’s terms to be set in the future and determined in the first instance by Covidien or its wholly owned subsidiary.
In discussing the procedural posture of the case, Laster noted that a stockholder filed a complaint in the Delaware Court of Chancery that "sought a preliminary injunction blocking the transaction on the grounds that (i) the top-up option failed to comply with Sections 152, 153 and 157 of the DGCL ... , (ii) the exercise of the top-up option would coerce stockholders to tender because of the threat of ‘appraisal dilution,’ (iii) the ev3 directors breached their fiduciary duties in granting the top-up option, and (iv) [Covidien] aided and abetted their breach."
After the court granted a motion to expedite, the parties entered into a memorandum of understanding, which called for comprehensive amendments to the top-up option and merger agreement to cure the statutory challenges and, in the court’s view, "provided [the plaintiff stockholder] with all the relief she could have hoped to achieve on the merits."
According to the opinion, the parties thereafter drafted settlement papers and attempted to agree on a fee award that the defendants would not oppose. The parties were unsuccessful, and the plaintiffs applied for a fee award of $1.1 million, while the defendants argued for a fee award of $525,000.
The court first considered the strength of the claim alleging the threat of "appraisal dilution." While it concluded that the plaintiff stockholder "obtained complete relief on this claim" by securing an agreement that the shares issued under the top-up option and any related consideration would not be considered for purposes of appraisal, the court deemed the resulting benefit to be "ephemeral at best." It did so upon finding that the plain language of Delaware’s appraisal statute, Section 262 of the DGCL, calls for the exclusion of the top-up option shares because the issuance of such shares and the receipt of cash or a promissory note in payment of those shares is an "element of value arising from the accomplishment or expectation of the merger." Even assuming that the appraisal statute did not govern, however, the court found "the real-world operation of the appraisal process" was unlikely to result in coercion from "appraisal dilution." Accordingly, the court awarded only $100,000 of the requested $1.1 million fee for the resolution of this claim.
The court next considered the benefits the litigation conferred upon ev3 and its stockholders by addressing the statutory problems created by the top-up option. The court found those benefits to be far more meaningful, as "the merger agreement, the top-up option and any shares issued upon its exercise likely were void," as originally structured.
First, the court found that the plaintiff stockholder had a strong argument that the top-up option did not comply with Section 157(b) of the DGCL, which requires that the option terms, including the consideration to be paid for the shares, be set forth in the certificate of incorporation "or in a resolution adopted by the board of directors providing for the creation and issue of such rights or options, and, in every case, shall be set forth or incorporated by reference in the instrument or instruments evidencing such rights or options."
The merger agreement, which the court found was the "instrument" evidencing the top-up option, arguably failed to set forth the consideration to be paid for the shares. Although the merger agreement "authorized the consideration for the top-up [option shares] to be paid with a promissory note, [it] failed to set forth the material terms of the note, including the terms of repayment, provisions for interest, whether the note will be secured, negotiable or transferable, or other material terms."
The court noted that Section 157(b) of the DGCL also requires that the terms be set forth in board resolutions and surmised that it was likely that there were no such board resolutions given the absence of terms in the merger agreement.
In addition, the court suggested that ev3 may have failed to comply with sections 153(a) and 157(d) of the DGCL, as it was not clear that the ev3 board of directors made a determination that the consideration to be received for the shares to be issued in the top-up option had a value at least equal to the par value of the top-up option shares.
Finally, the court found that the ev3 directors may have failed to satisfy their statutory obligation to determine the sufficiency of the consideration to be received for the shares to be issued in the top-up option because the directors did not make any such determinations under the terms of the merger agreement and instead left that determination to a future date.
The court rejected the defendants’ attempts to minimize the statutory problems by arguing that the directors generally knew what they were doing and that the top-up option shares would only briefly be outstanding, finding that statutory violations are not cured either by a general understanding or by such brevity.
Deeming these to be "serious statutory flaws," the court observed that the memorandum of understanding "administered a preventative cure." It contemplated an amendment to the merger agreement to spell out the terms of the promissory note, required the ev3 board to meet to approve the amended merger agreement and adopt an implementing resolution, and required Covidien to pay the par value of any top-up option shares in cash. Thus, by pursuing the litigation and obtaining this settlement, the court found that the plaintiff stockholder "and her counsel prevented the seeds of a future legal crisis from germinating." It held an award of $1 million to be "fair and reasonable compensation" for remedying such statutory concerns.
The ev3 opinion suggests a number of best practices for the drafting, negotiation and approval of top-up options. These include the following:
- The decision confirms that parties contemplating a top-up option should have a contractual agreement as to the effect of the top-up option on any appraisal proceeding. While perhaps not technically necessary, the court seemed to view favorably the contractual agreement of the parties that the effect of the shares issued in a top-up option, as well as the consideration payable for such shares, would not be considered in any appraisal proceeding. Such language, and related disclosure, has become common in two-step merger transactions.
- Merger agreements should include the terms of the top-up option, including the consideration to be paid for the issuance of the top-up option shares. If a promissory note is contemplated, the terms of the promissory note should be set forth in the merger agreement, including the principal amount (which can be fixed on a per share basis), the interest rate, term, security (if any), prepayment rights, transferability, negotiability and any other material terms. Although not required by the decision, the parties to the merger agreement should consider whether it is advisable to attach a form of promissory note to the merger agreement, as it should not be difficult to do so given the fact that all of the terms of the note should be known other than the final aggregate amount of the promissory note.
- The board of directors should specifically approve, by formal board resolution, the grant of a top-up option and the material terms thereof as expressed in the merger agreement. Board resolutions should be adopted that address the following points: the number of shares potentially subject to the top-up option; the express approval of the option terms as expressed in the merger agreement; and a statement concerning the value and sufficiency of the consideration payable upon exercise of the top-up option, including confirmation that the consideration is at least equal to the aggregate par value of the top-up option shares. Although payment of par value in cash is not required, especially if the resolutions recite that the value received is in excess of par value, the parties should consider including such a requirement given the fact that the vice chancellor viewed a cash payment favorably and such a requirement is not onerous.
Reprinted with permission from 3/30/2011 issue of the Delaware Business Court Insider©2011 ALM Media Properties LLC. Further duplication without permission is prohibited. All rights reserved.