Out with Fiduciary Out?

In our forthcoming article, “Out with Fiduciary Out?” we offer justification for one of the most renowned and highly controversial decisions in Delaware in the last 20 years, Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003).

Merger and acquisition agreements (“M&A”) play a crucial role in the life cycle of a corporation. They determine the direction in which a corporation is heading and have a direct impact on shareholders’ returns, and hence entail a very complicated and costly process. The process is further complicated by the time gap between the signing of the agreement after the boards’ approval, and the closing of the deal after the shareholders’ approval. A potential acquirer does not want to incur significant expenses only to find that it was outbid by a competitor. Management and boards often prefer to avoid the uncertainty of M&A transactions. Therefore, the parties may agree to lock-up the agreement, namely, agree that the target shall not consider any other offers once the deal is signed.

In Omnicare, the Delaware Supreme Court (in a rare, 3-2, split decision) ruled that the board of a public target company cannot decide to completely lock up a merger. Hence, in most cases the merger agreement must include a fiduciary out clause, enabling the board and the company, inter alia, to terminate the agreement if a superior offer arrives before the deal is approved by the shareholders. If the agreement does not include such an exit clause, the deal may be deemed as “preclusive and coercive” and the board may be regarded as having failed in fulfilment of  its duties.

The ruling is highly problematic and has received much attention by courts, practitioners and legal scholars. The Omnicare decision has been widely criticized by practitioners and scholars, echoing the opinion of the dissenting minority in the case that prohibiting a complete lock-up would be detrimental to the interests of the company in a myriad of circumstances.

According to those criticisms, prohibition on a complete lock-up suffers from an analytical weakness that is hard to justify: a complete lock-up, including the exclusion of a fiduciary out provision, may serve the interests of shareholders. The bidder may attribute very high value to deal certainty, for which it may be willing to compensate shareholders in excess of any other offer. There may be parties for whom the value of the deal’s certainty is extremely high. Eliminating the ability to lock-up the deal would thus discourage them from making an offer at all or could significantly reduce the price they would be willing to pay for the target. Given this view, a fiduciary out clause is essentially an option that allows the target to terminate the deal if a superior offer is proffered. Mandating the inclusion of a fiduciary out clause is thus no different from forcing the target to purchase an exit option. In such cases, the price of the option may be too high, as any option could be and not worthwhile for the target to purchase. Mandating such purchase would invariably generate a social loss.

No persuasive justification has been provided to explain this anomaly, which led the Delaware Courts to narrow the scope of the requirement as much as possible. Vice Chancellor Lamb went as far as noting that “Omnicare is of questionable continued vitality.”

Can there be any justification for a fiduciary out requirement?

Some scholars have provided various explanations to overcome this analytical problem with the Omnicare decision and suggested justifications for the ruling. In our article, we argue that these justifications do not fully answer the problem that the Omnicare decision generates for discouraging potential offers, and we offer justification for the Omnicare ruling which has important legal ramifications.

In our view, the problem with a merger agreement that includes a complete lock-up but excludes a fiduciary out clause is not that it forecloses the possibility of receiving a better offer in the future, but that it bars the most effective method of monitoring the functioning of the board—namely, subjecting it to the market test. Therefore, the main purpose of the Omnicare ruling is not necessarily to maximize shareholder returns, protect their rights, or fulfill the board’s duty to be fully informed; rather, its main purpose is to enable effective oversight over end-game decisions by exposing such decisions to market powers (assuming, of course, there is an efficient market for monitoring such types of deals).

Directors, as any other agent, might prefer their own self-interests over those of the shareholders. This fear is especially relevant in end-game decisions. It is quite difficult for shareholders to know whether the deal being pursued by the board is optimal. With information regarding the potential value of the target to various market players being very costly to obtain, shareholders have no way of directly ascertaining whether the offer price is the highest possible one. Lacking such information, they cannot monitor the board effectively, which may lead them to approve unfavorable of suboptimal deals. The most effective mechanism that reins in opportunistic behavior on the part of the board and provide monitoring over its decisions, is the market. Fiduciary out clauses invite market players to submit bids for the target even after a deal with another acquirer has been finalized. In the presence of such clauses, the board knows that if the deal it is pursuing is not the optimal one for shareholders, the market may expose that fact via the emergence of a superior offer. The complete lock-up of a merger insulates it from market oversight. Absent market oversight, the board functions without effective monitoring at a time when such monitoring is critical. Therefore, prohibiting a complete lock-up is intended to prevent the board from functioning without effective oversight. It does not stem from a conventional understanding of the fiduciary duties, but rather from a broader consideration of not enabling the board to circumvent effective oversight.

This rationale, which as suggested in our article, underlies the prohibition on a complete lock-up, has important legal implications, and also discussed are the implications of the oversight rationale for fine-tuning the Omnicare ruling that both narrow and widen its application. On the one hand, it may narrow the Omnicare ruling and exclude its application to situations where no oversight is needed, if it is clear that the board does not stand to gain even indirect benefits from the deal—such as maintaining their board seats in the merged company or enjoying any other direct or indirect gain. In such case, the need for oversight over the board’s actions is weaker, thereby permitting a complete lock-up of the deal. On the other hand, the proposed rationale may widen the Omnicare ruling warrant the enjoining of a merger for which there is no fiduciary out clause, even when there is no intervening bidder. This approach is contrary to the narrow interpretation of Omnicare adopted by the courts in subsequent cases, which more leniently treated mergers lacking an intervening bidder. According to the oversight rationale, we argue that the fact that there is no intervening bidder only exacerbates the oversight problem and does not serve as a mitigating factor, and therefore, even in such cases, the merger should be enjoined if it did not include a fiduciary out. Similarly, the rationale also calls for full application of the Omnicare ruling in cases of immediate shareholder consent, which is in contrast with rulings that exempted such cases from the fiduciary out requirement. The reason for this is because such immediate consent does not mollify the oversight concern and thus the fiduciary out requirement should also apply to such cases.

The Omnicare decision is still with us. We tend to believe that the oversight justification may place it on firmer ground.

The article is available for download here.