Related Practices

• Healthcare Business
• Mergers and Acquisitions

On April 4, 2003, the Delaware Supreme Court issued its much anticipated opinion in Omnicare, Inc. v. NCS Healthcare, Inc.  The opinion sets forth the reasoning behind the Court's summary order issued on December 10, 2002, which reversed a decision of the Delaware Court of Chancery and enjoined a planned merger between NCS Healthcare, Inc. ("NCS") and Genesis Health Ventures, Inc. ("Genesis").  In a rare, divided 3-2 decision, the Delaware Supreme Court held that certain customary "deal protection" measures adopted by NCS and Genesis were invalid and unenforceable under Delaware law.  Although the full scope and effect of the Court's decision remains unclear, both acquiring and target companies should carefully consider the impact of Omnicare when structuring "deal protection" measures in the future.

Background
In 2002, NCS was suffering from severe financial difficulties.  Seeking to avoid bankruptcy, the NCS board of directors directed management to investigate various alternatives,  including possible business combinations.  Among the offers received, NCS considered several acquisition offers from Omnicare, Inc. ("Omnicare"), NCS's largest competitor, and Genesis.  The NCS board rejected the initial overtures by Omnicare because its proposals were structured as asset sales in bankruptcy that failed to cover NCS's outstanding debt, paid nothing to the NCS stockholders and were subject to certain closing conditions including the satisfactory completion of due diligence.  In contrast, Genesis proposed a more attractive transaction in which the NCS stockholders would receive approximately $24 million in Genesis stock and all the outstanding debt of NCS would be paid in full.  Consequently, the NCS board authorized management to negotiate the terms of a merger with Genesis.

Genesis had previously lost a bidding war to Omnicare in a different transaction and, consequently, wanted to avoid the role of "stalking horse" in NCS's negotiations with Omnicare.  Therefore, as a condition to further negotiations, Genesis insisted that NCS agree to exclusivity agreements and "lock-ups" in the proposed transaction.

Upon suspecting that NCS was engaged in merger negotiations with another suitor, Omnicare made another unsolicited and competing bid to acquire NCS.  The terms of this latest proposal contained more attractive economic terms than the Genesis proposal and no longer involved a sale in bankruptcy.  However, it remained subject to numerous closing conditions, including a due diligence contingency.

The NCS board weighed the potential loss of the Genesis deal with the uncertainty associated with the latest Omnicare offer and concluded that it was in the best interests of NCS to go forward with the Genesis transaction.  Accordingly, on July 28, 2002, the NCS board approved a proposed merger between NCS and Genesis.

As required under Section 251 of the Delaware General Corporation Law (the "DGCL") and as a condition to the closing of the proposed Genesis transaction, the NCS board was required to hold a meeting of NCS's stockholders to consider and vote upon the merger.  As is customary in public company transactions of this nature, the merger agreement and related documentation contained heavily negotiated "deal protection" measures intended to ensure that the stockholders would be given the opportunity to vote on the proposed transaction and that the transaction had the best possible chance of being approved.  Among these measures, the merger agreement contained a provision authorized by Section 251(c) of the DGCL that required NCS to hold the stockholders meeting to consider the Genesis transaction even if the board's recommendation in favor of the merger was later withdrawn for any reason, including the receipt of a "superior" competing offer.  Additionally, the NCS board agreed to omit a "fiduciary out" clause, which would have allowed the NCS board to terminate the merger agreement if it withdrew its recommendation in favor of the merger.

Genesis also required the two majority stockholders of NCS, who were also members of the NCS board, to enter into "lock-up" agreements with Genesis committing them to vote their shares in favor of the Genesis merger.  These stockholders held shares representing approximately 65% of NCS's voting power.  Notably, the "lock up" agreements also did not contain "fiduciary out" clauses.

After the merger agreement was executed, but prior to the stockholder meeting, Omnicare made another offer to acquire NCS.  This offer was at a higher price than the proposed Genesis transaction and was made irrevocable.  In light of this new proposal, the NCS board of directors withdrew its prior recommendation in favor of the Genesis transaction.  Nevertheless, under the terms of the "force the vote" provision, NCS proceeded with the stockholders meeting and submitted the Genesis merger to its stockholders for their consideration.  Since the "lock-up" agreements committed more than a majority of the outstanding NCS shares to vote in favor of the Genesis merger and neither the merger agreement nor the "lock-up" agreements contained "fiduciary out" clauses, stockholder approval of the Genesis merger was virtually assured.

Omnicare subsequently instituted a lawsuit to enjoin the consummation of the Genesis merger.

Delaware Supreme Court Decision in Omnicare
In a bitterly divided 3-2 decision, the Delaware Supreme Court reversed the Delaware Chancery Court and held that the particular "deal protection" measures utilized by NCS and Genesis were invalid and unenforceable.  In reaching this conclusion, the Court applied the enhanced scrutiny test set forth in Unocal and concluded that the combination of these devices acting in concert with the factual backdrop constituted "coercive" and "preclusive" measures.(Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).  The use of the Unocal test in this case was a significant departure from the traditional application of the Unocal test.  The Unocal test had been primarily used in the context of "hostile" takeover situations in which a target board institutes defensive actions to preclude a change in control of the target.  Omnicare did not involve the protection of the target board from a hostile takeover, but, rather, involved the protection of a business combination transaction from a subsequent superior offer.)

In articulating the Unocal standard, the Court stated that the directors of a corporation have the initial burden of demonstrating that (i) they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and (ii) their defensive response was reasonable in relation to the threat posed.

The Court first considered whether the directors satisfied the first prong of the Unocal test.  In concluding that the NCS board acted in good faith after conducting a reasonable investigation, the Court gave considerable weight to the fact that NCS established an independent committee of the board to negotiate and consider the transaction and that no conflicts of interest appeared present in the negotiation and approval of the merger.

The Court then applied the second prong of the Unocal test.  To determine whether the directors effectively demonstrated that their defensive response was reasonable in relation to the threat posed, the Court articulated a two step analysis.  First, the deal protection devices must not be "coercive" or "preclusive."  Second, the directors must demonstrate that the adoption of such protection devices was within a range of reasonable responses to the threat perceived.

Under existing Delaware jurisprudence, "deal protection" devices are deemed to be "coercive" if they are intended to force upon the stockholders a management-sponsored alternative to a "hostile" offer or if they cause the stockholders to vote in favor of the proposed transaction for some reason other than the merits of the transaction.  "Deal protection" devices are deemed to be "preclusive" if they have the effect of depriving the stockholders of the right to receive any offers, precluding a bidder from seeking control of a target company or preventing the stockholders from considering a superior offer.

The Court found the "deal protection" measures contained in the Genesis transaction to be coercive and preclusive and, therefore, a violation of the Unocal test.  As the Court explained, "[t]he deal protection devices adopted by the NCS board were designed to coerce the consummation of the Genesis merger and preclude the consideration of any superior transactions."  Since the "deal protection" devices were deemed to be "coercive" and "preclusive," they were not reasonable in relation to the threat posed (i.e., the threat of losing the Genesis offer), and, accordingly, unenforceable under Delaware law.

The Court further stated that the "deal protection" devices were also invalid and unenforceable because they prevented the NCS board from faithfully discharging its fiduciary duties.  Under Delaware law, directors of a corporation have a continuing obligation to discharge their fiduciary obligations, even after a merger agreement is executed.  To the extent that a contract requires a board to act or not act in a manner that limits the exercise of its fiduciary responsibilities, it is invalid and unenforceable under Delaware law.  The Court held that "the NCS Board did not have authority to accede to the Genesis demand for an absolute lock-up."  Instead the NCS board should have had a "fiduciary out" clause in the merger agreement to allow the board to terminate the merger agreement in the face of a "superior" offer.

Impact of the Omnicare Decision
As a bright line rule, the Omnicare case clearly indicates that a Section 251(c) "force the vote" provision cannot be utilized in connection with "lock-up" agreements that would ensure an affirmative stockholder vote unless the board of directors of the target company retains a "fiduciary out" that would enable it to later terminate the merger agreement in favor of a "superior" offer.  On the other hand, without further limitations imposed by the Delaware Supreme Court, it is reasonable to assume that acquirors can demand  Section 251(c) "force the vote" provisions in merger agreements as long as they contain appropriate "fiduciary out" clauses or the acquirors do not also obtain "lock-up" agreements from holders of a majority of the stockholder voting power in the target company.

The Court's opinion leaves open the issue of whether, and at what point, a "lock up" of less than a majority of the target's voting control, coupled with a "force the vote" provision, requires a "fiduciary out" clause.  Although the Court in Omnicare indicates its decision hinged on the fact that more than a majority of the outstanding NCS shares were "locked-up," significant influence of a public company may be exercised from an ownership interest which is less than a majority.  Until the Court further addresses this issue, we recommend that where an acquiror is demanding a Section 251(c) "force the vote" provision as well as "lock up" agreements from target stockholders that approach 30%-40% of the target's outstanding voting securities, such acquiror should also strongly consider accepting "fiduciary out" clauses.

The Court's opinion also does not directly address the validity of other types of protective devices that are often adopted to protect transactions from subsequent offers such as "break-up" fees or stock options exercisable upon termination of a transaction.  Although the majority opinion and the two dissents expressly limit the holding of this case to its specific facts, the Delaware Supreme Court suggests that any "deal protection" measures utilized in business combinations will be deemed invalid and unenforceable if the combination of these devices are intended to "coerce" the target stockholders into approving a proposed transaction or to "preclude" them from considering an alternative transaction.  The Court has also indicated that these measures will be struck down if they effectively eliminate the ability of a target company's board of directors to discharge its fiduciary duties as future circumstances develop.  Consequently, in incorporating such devices into the structure of business combinations, acquirors should carefully consider whether the combination of these or other "deal protection" measures under the particular factual backdrop would violate the underlying rationale of Omnicare.

If you would like additional information or have any questions regarding this or any other corporate fiduciary duty matter, please contact your Cohen & Grigsby attorney.