Increased judicial scrutiny has led parties to change certain terms of their top-up options. Professor Steven M. Davidoff examines these modifications and their effectiveness.
Top-up options have become a routine feature of tender offers (see Box, What is a Top-up Option?). According to FactSet MergerMetrics, a top-up option was included in nearly 100% of all agreed tender offers announced in 2009 and 2010. This compares to only 35% of tender offers in 2004.
The increased use of the tender offer structure and top-ups has raised new legal issues, and recent stockholder litigation has focused on the validity of certain aspects of top-up options. In response to this litigation threat, parties have begun to modify the terms of their top-ups.
Stockholder litigation over the terms of top-up options have led to settlements in a number of recent acquisitions, including the American Italian Pasta Company, ev3 Inc. and Protection One, Inc. transactions (see PLC What's Market, Ralcorp Holdings, Inc./American Italian Pasta Company Merger Agreement Summary, Covidien Group S.a.r.l./ev3 Inc. Merger Agreement Summary and GTCR/Protection One, Inc. Merger Agreement Summary).
The settlements are due in part to the recent interest of the Delaware judiciary. In June, Vice Chancellor Laster ordered an expedited hearing on the legality of a top-up option granted by ev3 to its buyer, Covidien. Laster based his order primarily on the potentially adverse effects of a top-up option on the appraisal process.
However, Laster also noted that it was an open question about whether top-up options are inherently coercive, stating that "[t]he potential coerciveness of these options, and the potential validity…is of significant import." After Laster's order was given, the parties quickly settled their litigation by modifying the terms of the ev3 top-up option.
Recent stockholder litigation has focused on the following aspects of top-up options:
Effect of the exercise of a top-up option on the determination of fair value in any stockholder appraisal rights action under Section 262 of the Delaware General Corporation Law (DGCL).
Ability of a buyer to pay for shares received under a top-up option with a promissory note.
Validity of a top-up option which can be exercised in whole or in part or without time restrictions.
Delaware disclosure requirements applicable to the terms and potential effects of a top-up option.
In response, parties have begun modifying related terms in their top-up options to address these issues.
In an appraisal proceeding, under DGCL Section 262(h), Delaware courts must take into account the fair value of a target's shares at the time of the merger.
In recent top-up litigation, plaintiffs have alleged that the massive dilution caused by the top-up issuance negatively affects the per share value of the target. In theory, the payment of the option exercise price should alleviate this problem because the buyer pays the same price as the tender offer price to purchase these shares.
However, in a typical top-up, the buyer does not pay cash. This is because the amount of cash required can amount to billions. Instead, the exercise price is paid with a promissory note. The promissory note often contains non-market terms or, due to margin requirements, is otherwise not fully secured.
In these cases, plaintiffs have argued that the buyer is paying less than the offer price for the shares (that is, the market value of the promissory note). This value may potentially be taken into account in any appraisal action and negatively affect a stockholder's appraisal remedy.
Parties have recently attempted to address this issue in acquisition agreements by excluding the top-up option from the appraisal evaluation. Some agreements have included language similar to the following provision in the ICx Technologies acquisition agreement (see PLC What's Market, FLIR Systems, Inc./ICx Technologies, Inc. Merger Agreement Summary):
"The parties agree and acknowledge that in any appraisal proceeding with respect to the Dissenting Shares and to the fullest extent permitted by applicable Law, the fair value of the Dissenting Shares shall be determined in accordance with Section 262(h) of the DGCL without regard to the Top-Up Option, the Top-Up Shares or any consideration paid or delivered by [buyer] to [ICx] in payment for the Top-Up Shares."
However, Mark Morton of Potter Anderson & Corroon LLP has pointed out a potential problem with this language. He explains that the provision should work, either as a contractual matter or because of the equitable remedy of estoppel, if the exercise of the option would have harmed the party seeking appraisal. The buyer should not be able to benefit from the dilution caused by the top-up option exercise.
What is less clear, though, is what happens if the dilution can help the stockholder seeking appraisal. In that case, the company may not legally have the right to contractually agree to a treatment which excludes the consideration of the top-up option.
For example, a court may conclude that the merger price is greater than the value of the target as a going concern. This is most likely the case if a buyer is willing to pay a full premium for control and expects to benefit from the synergies caused by the merger. In an appraisal, the stockholder is not entitled to either benefit. Keeping in mind that a target may have to issue a large number of shares for the buyer to reach the 90% threshold, the effect is as follows:
Assume a tender offer at a price of $1 per share with an 80% tender (8 million shares). The top-up option is exercised to provide the buyer 10% of the target's shares (10 million shares). The buyer now owns 18 million of the 20 million shares. Assume that the merger price (and option price) was $1. Without the cash from the top-up, assume the "going concern" value would have been $9 million (10% less than the merger price), or $.90 per share. But if the top-up is exercised, then the going concern value is probably $9 million, plus the $10 million in cash from the exercise of the option, or $19 million. Therefore, the total price at going concern value is $.95 per share ($19 million for 20 million shares).
For the merger agreement provision in ICx to work, the party seeking the appraisal must be harmed by the issuance of the shares from the top-up option. However, in this case the target stockholders are benefitting.
To address this point, Morton recommends the following language:
"The parties agree and acknowledge that in any appraisal proceeding with respect to the Dissenting Shares, and to the fullest extent permitted by applicable law, the Surviving Corporation shall not assert that the Top-Up Option, the issuance of the Top-Up Shares or the payment by [Buyer] to [Target] of any consideration for the Top-Up Shares should be considered by the Court in connection with its determination in accordance with Section 262(h) of the DGCL of the fair value of the Dissenting Shares."
Under this approach, it is clear that the buyer (but not the stockholders seeking appraisal) is precluded from asserting the effect of the top-up option. This approach undermines an argument that could be raised concerning the ICx language: that by excluding the top-up option in all circumstances (even if the top-up option has a positive impact), the company may be artificially (and impermissibly) lowering the value of the company (and the dissenting stockholders' appraisal remedy).
Stockholder litigation challenging promissory note payments in top-up option exercises has encompassed two fundamental claims. First, in some transactions (such as in ev3), the terms of the promissory note issuable to the buyer are not set forth in the acquisition agreement. Instead, the acquisition agreement provides that the terms will be determined in future negotiations between the target board and the buyer. Plaintiffs' attorneys have argued that these provisions are vague and violate a board's duties to set the price of stock at the time of issuance.
Accompanying this has been a related claim that these promissory notes violate DGCL Sections 152 and 157. These sections require that the consideration paid for stock is both:
Determined by the board of directors.
Not less than the par value of the shares.
In the Protection One litigation, for example, claims were brought stating that there was no attempt to value the promissory note. Plaintiffs have also challenged promissory notes which paid the entire consideration, including the consideration attributable to par value. Plaintiffs have alleged that this violates the Section 157 requirement that a purchaser of shares pay not less than the par value of a company's shares.
These claims can be easily addressed. Parties should set the terms of the promissory note up front in the acquisition agreement and these terms should be set based on market terms. In addition, the par value of the shares being paid for should be paid in cash to ensure that a Section 157 claim can be rebutted. Finally, and if not unduly burdensome, the board should actively make a determination as to the value of the note and base its conclusion on independent financial advice.
Plaintiffs' attorneys, as illustrated by the American Italian Pasta litigation, have also increasingly claimed that particular terms of top-up options are coercive. This type of litigation has had more success in cases where the top-up option can be exercised in whole or in part or when the shares delivered under these options are allowed to be voted in a long-form merger.
These arguments center on the claim that the top-up option places the timing of the squeeze-out merger at the discretion of the buyer. Accordingly, stockholders are coerced to tender the offer to collect their consideration on a timely basis. The buyer-controlled timing of the short-form merger is also important because the assessment under DGCL Section 262(h) is made as of the time of the merger. These claims are particularly ripe if the top-up option does not increase the buyer's shareholdings above the 90% level and a long-form merger (and stockholder vote) is necessary.
To mitigate these claims, the acquisition agreement should require the top-up to be exercised in full and within a short period of time of the closing of the tender offer. Top-up thresholds should preferably ensure that the party achieves a 90% value to avoid issues with the timing of a long-form merger. If the target does not have sufficient authorized shares to ensure that the buyer reaches the 90% level, the target should require the buyer to engage in a long-form merger as soon as practicable after completing the transaction if it does not reach the short-form threshold.
In almost all of the litigation challenging top-up options, the plaintiffs have alleged inadequate disclosure. These claims have largely asserted that the terms of any financing for the promissory notes have not been disclosed nor has the effect of the top-up exercise and the massive dilution it will produce.
While disclosure claims are brought these days in almost every M&A stockholder litigation, these types of top-up disclosure claims are easily preventable. Tender offer documents should disclose the:
Effects of the top-ups.
Terms of the top-up.
Terms of the promissory note.
Parties should also consider including a form of the promissory note as an exhibit to the Schedule TO.
In the background of all of these claims is the question regarding the ultimate validity of the top-up option itself. As Vice Chancellor Laster alluded to, this claim has yet to be litigated in a Delaware court. While it is likely that Delaware courts will uphold top-up options, the relatively easy changes suggested above should help ensure that a top-up option survives a judicial challenge.
For a long-form agreement for the negotiated acquisition of a US public corporation by a front-end tender offer followed by a merger, drafted in favor of the buyer, see Standard Document, Merger Agreement (Tender Offer, Pro-buyer) (www.practicallaw.com/3-500-5939).
A top-up option (once triggered) allows the buyer to purchase an amount of new target company shares that, when combined with the stock acquired in the tender offer, equals enough shares to meet the 90% ownership threshold. Reaching the 90% ownership threshold permits a buyer to complete a short-form merger with the target almost immediately after the close of the tender offer and alleviates the requirement for a stockholder vote. The top-up option trigger is typically the minimum tender offer condition of 50% of the target's fully-diluted shares.