Mergers and acquisitions are on the rise.  With the decrease in initial public offerings during the past few years, more and more business owners are looking toward sale or merger of their companies in order achieve liquidity.  No matter how attractive an offer to purchase the company may appear to be at the beginning, the directors of the target company have to diligently examine the proposal and carefully consider all material information available, including comparison of the current offer with other alternatives.

If our business is to be sold or merged out, what are some of our directors’ responsibilities?  When it becomes clear that the target corporation will be sold, the board of directors of the target owes a fiduciary duty to the shareholders to obtain the best value reasonably available under the circumstances, and may even have a fiduciary duty to run a fair auction. The board cannot favor one bidder over another when both bidders are offering an adequate price.  Overreaching deal protection mechanisms like voting agreements, no-shop provisions, lock-up options and other options favoring one bidder over another without any fiduciary-out provisions could result in a breach of fiduciary duties, and may be unenforceable.

Examples of overreaching deal protection mechanisms.  Merger and acquisition agreements may include certain provisions in the agreement that potentially could obstruct competing offers. The most common of such clauses are “no-shop” provisions that prohibit the company from soliciting bids or negotiating with other interested parties, unreasonable “break up fee” clauses that require the company to pay a substantial fee if the transaction is abandoned as a result of a competing bid, voting agreements, and “force-the-vote” provisions without a “fiduciary out” provision.  A voting agreement is a lock-up device in a merger agreement that commits shareholders of the target company to vote for the deal.   A force-the-vote provision could be another mechanism in a merger agreement that locks the deal.  It could benefit the buyer by requiring the board of the target company to submit the buyer’s proposal to a shareholder vote, notwithstanding any change or withdrawal of the target board’s recommendation as a result of a topping bid.  This effectively results in taking away from the target’s board the right to terminate the deal and transferring such power to the shareholders to determine which offer is superior.  A fiduciary out provision generally gives the board the ability to exercise its fiduciary duties irrespective of the lock-up options and withdraw from closing a deal in favor of a better offer by another bidder.

How do the courts view these deal provisions?  This article briefly analyzes current Delaware and California case law with respect to the fiduciary duties of the directors of a target company involved in an acquisition or merger.  Important Note:  the directors of a privately held company owe the same duties of care to their company’s shareholders as do the directors of a publicly held company.

The Delaware courts have nullified certain provisions of the negotiated merger transaction such as no-shop and force-the-vote provisions, lock-up options without a fiduciary out clause, or merger agreements that are subject to unreasonably high break-up fees.  Based on Omnicare Inc. v. NCS Healthcare Inc. (2003) 818 A.2d 914, a target company’s board should insist that any merger agreement it approves that contains a force-the-vote and other lock-up provisions also contains an effective fiduciary out provision.  As a result, directors of Delaware corporations who are considering a merger or acquisition must exercise great caution.  The Delaware courts have held that no-shop clauses are enforceable if the board concludes that it was reasonably necessary to induce or protect an attractive transaction and a breach of the no-shop provision will not result in an unreasonably large break up fee.  The board of directors of a Delaware company should consider whether the break up fee is large enough to deter competing offers substantially greater in value than the proposal currently under consideration, or whether the break-up fee would have an adverse impact on the company.

California courts, on the other hand, have held that there is no breach of California directors’ fiduciary duty if the acquisition agreement requires the board to refrain from entering into competing contracts until the shareholders consider the initial proposal.  This means that the target company’s board can’t be prevented from providing information to a prospective bidder making a competitive offer.  While the target’s board may agree to refrain from entering into any competing agreements, they should not agree to no-shop provisions that prevent the company from merely providing information to a competing bidder.  In addition, the board may not withhold information from its shareholders regarding a potentially more attractive competing offer.  The shareholders must be presented with the choice of accepting or rejecting an acquisition proposal in light of a competing offer.  California courts have not disagreed significantly with Delaware on the issue of break-up fees and have held that these fees may be lawful, so long as they are not so large they would unreasonably deter the target company from considering a competing offer.  In any event, California provides more flexibility for California corporations than does Delaware in obtaining merger approval from shareholders.

What key points should our directors keep in mind?  Above all, the company’s directors should strive to exercise due care and act in good faith when making business decisions on behalf of the company.  Among other things, directors facing an acquisition or merger transaction should:

• Act cautiously in limiting their ability to respond to a more favorable offer.
• Avoid haste, as well as the appearance of acting in haste.
• Before executing an acquisition agreement, fully inform themselves of competing sale opportunities.
• Consider whether seeking advice from outside experts (outside counsel, accountants, etc.) can help the board establish that they made an informed, well thought out decision. 
• Consider approaching other potential acquirers to evaluate competing offers, if any. 
• Document all its deliberations to the maximum extent possible. 

Always preserve the ability in an acquisition agreement to entertain and accept competing offers from other bidders.