Ball and Chain

The debate continues in Delaware over how courts should evaluate clauses in merger agreements designed to prevent wandering eyes. 

From The Daily Deal, Vol.2, No.73, May 23, 2000
Copyright ©2000 The Deal LLC
Reprinted with permission. All rights reserved.

Delaware Vice Chancellor Leo Strine's decision in McMillan vs. Intercargo adds a new chapter to the growing body of case law on the proper standard of review for deal protection provisions.  And defensive-minded managers should like what they read.

The decision, issued on April 20, involved a claim by stockholders that the directors of Intercargo had breached their fiduciary duty in connection with the acquisition of Intercargo by XL America for $12 a share.  At that price, the equity value of the deal was approximately $88 million.

The complaint alleged, among other things, that the directors had not satisfied their duties under Revlon Inc. vs. MacAndrews & Forbes Holdings Inc. and that the merger agreement contained a preclusive and coercive termination fee of $3.1 million plus expenses.  The fee (excluding expenses) amounted to 3.5% of the deal value.  The shareholders also challenged the merger agreement's no-shop provision.

Strine granted the defense motion for summary judgment and dismissed the case.  But first, he renewed his debate with Vice Chancellor Myron Steele about whether deal protections are defensive and reviewable under Unocal Corp. vs. Mesa Petroleum Co. or merely the business judgment rule.

In footnote 62, which has become known as the "duck footnote," Strine seems to conclude that no-shops, no-talks, termination fees and other devices are provisions that protect one deal "from" other rival deals and therefore all are reviewable under Unocal.  Strine writes: "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 (for example, 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 more expensive to consummate a competing transaction and by providing compensation to the 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."  [emphasis in original].

One is left to wonder what other contractual provisions in a merger agreement will be deemed "deal protections" by Strine.

While referring to the "deal protection" provisions of the merger agreement as "rather ordinary," Strine also noted that "in purely percentage terms, the termination fee was at the high end of what our courts have approved."  In light of the size of this deal (only $88 million), it is a little surprising to see Strine refer to the termination fee as at the "high end."  Moreover, in one decision he cites (Matador Capitol Management Corp. vs. BRCHoldings Inc.), the termination fee represented approximately 4% of the transaction value.  And in another decision cited in Matador with approval, the Delaware Superior Court noted that termination fees in the range of 1% to 5% of transaction value are generally considered reasonable.  In light of these cases, the small size of the Intercargo deal and the general view of many practitioners that a 5% fee is not unreasonable for a deal like this one, his characterization seemed a little surprising.

More interesting, however, is Strine's next remark about the fee:  "As important, the termination fee was structured so as to be payable only in the event" of a no vote coupled with a better deal in 90 days or another transaction proposal within the year.  "This structure ensured that the Intercargo stockholders would not cast their vote in fear that a 'no' vote alone would trigger the fee; the fee would be payable only if the stockholders were to get a better deal."

It is unclear whether this remark portends future discussion by Strine about fees payable on a naked no vote.

The Intercargo decision also provides some limited guidance on whether reckless conduct falls within the protection of Delaware General Corporation Law Section 102(b)(7), under which corporations may limit the liability of its directors.  In discussing whether the plaintiffs stated a Revlon claim, Strine observes that, in light of the company's Section 102(b)(7) provision, the plaintiff will be able to maintain a cause of action only if there are allegations of bad faith, self-interest "or other intentional misconduct" amounting to a breach of the duty of loyalty.  In referring to "other intentional misconduct," Strine appears to be characterizing the kind of misconduct that will fall outside of 102(b)(7) as including only intentional misconduct.

If that is the case, then bad faith would include intentional acts, but not reckless acts.  Strine's remarks represent the first meaningful judicial guidance on where the court may draw the line on this issue.

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