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.
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
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
Investment Banker Conflicts of Interest: In re Del Monte Foods
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
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:
— Merger Agreement Implications
(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.
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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