Calling a Duck a Duck: Determining the Validity of Deal Protection Provisions in Merger of Equals Transactions

Monday, January 1st, 2001 at 12:00 am by Mark Lebovitch and Peter B. Morrison
Mark Lebovitch and Peter B. Morrison, Calling a Duck a Duck: Determining the Validity of Deal Protection Provisions in Merger of Equals Transactions, 2001 Colum. Bus. L. Rev. 1

When boards of directors negotiate ‘merger of equals‘ transactions, they often include in the merger agreement various contract provisions that improve the likelihood that the transaction will close. These contract provisions curtail the would-be merger partners’ ability to respond favorably to a third party’s unsolicited merger or acquisition bid. Contractual provisions that make the successful completion of a first-negotiated deal more likely by making the successful acceptance of a competing bid less likely are generally referred to as ‘Deal Protections.‘ These include, for example: no-shop, no-talk, required recommendation, required presentation for vote, termination fee, no termination until a preset date, and cross-option provisions.

The standard of review that Delaware courts will apply to a board’s decision to adopt these contractual provisions in merger of equals transactions remains an open question. Two competing possibilities have emerged. The first possibility is that Deal Protections are subject to the reasonableness/proportionality test crafted in Unocal Corp. v. Mesa Petroleum Inc. The other possibility is that courts should apply the deferential business judgment rule to directors’ decisions to embed Deal Protections in merger agreements.

Litigation regarding a number of recent merger of equals transactions required the Delaware Court of Chancery to confront the questions we address in this article: Which standard of review should the court apply to directors’ adoption of Deal Protections? And how will the court conduct that analysis? In answering these questions, the Court of Chancery seems divided. One Vice Chancellor has suggested that ‘just as a duck is a duck, a deal protection is a defensive measure,‘ which should be reviewed under the Unocal reasonableness/proportionality test. The Chancellor has implicitly endorsed this view. Another Vice Chancellor (who has recently become a Justice on the Delaware Supreme Court), however, has categorized a no-talk provision as a run-of-the-mill contract term, which the business judgment rule protects from judicial second-guessing.

In this article, we consider the legal and policy-based arguments underlying these competing possibilities, and conclude that Unocal’s enhanced scrutiny is the proper standard for judicial review of Deal Protections. Next, we offer a formula, distilled from relevant case law, that courts have implicitly utilized in performing their analyses of Deal Protections. In short, notwithstanding substantive review of Deal Protections, an adequately advised and properly functioning board can confidently agree to such terms.

Section II discusses the courts’ recent application of the two alternative standards of review. Part A of Section II details the legal and policy arguments favoring Unocal’s application in the context of judicial review of Deal Protections. Part B of Section II outlines and refutes the legal and policy based arguments favoring the application of the business judgment rule to such cases.

After addressing why Unocal applies, Section III presents a formula for this analysis, which we believe the Delaware Court of Chancery has already implicitly adopted. Because the application of Unocal is often fact-intensive, and therefore difficult to predict, this explicit articulation of the formula is an effort to bring clarity and predictability to the application of enhanced scrutiny in the merger of equals context. First, the court will inquire into the reasonableness of the board’s decision to adopt the provisions at the time they were adopted. A provision that is a reasonable restriction on the board at the time it is adopted should not be struck at a later date simply because of changed circumstances or an unexpected bid. Second, the reasonableness of the board’s decision will be judged by weighing (1) the effect of the Deal Protections employed, against (2) the thoroughness of a board’s market check, and/or (3) the breadth of the merger agreement’s fiduciary out, if one exists. The severity of the Deal Protection bears a positive correlation to the need for a comprehensive market check and/or broad fiduciary out.

This application of Unocal in no way signals a death-knell for Deal Protections. Rather, it merely requires that directors, as agents, not appear to place their allegiance to a potential merger partner ahead of their loyalty to their principals, the stockholders. This view is consistent with Unocal’s original purpose as a director-enabling mechanism.

Author Information

Both authors concluded one-year terms as law clerks for the Court of Chancery of the State of Delaware. Mark Lebovitch clerked for Vice Chancellor Stephen P. Lamb and Peter B. Morrison clerked for Chancellor William B. Chandler III.