Deal Protection Measures for Mergers and Acquisitions or How Delaware Could Once Again Impact Canadian Corporate Law.

For more than a year now, the international mergers and acquisitions market has been experiencing a boom. According to the Bloomberg Web site (www.bloomberg.com), over US$2.6 billion in transactions were negotiated in 2005, representing the highest volume since 2000; and Canada is keeping up with the pack with over US$114 billion in mergers and acquisitions negotiated in 2005. Several Canadian companies were players in major transactions as targets of international corporations - most of them American - but also as initiators of bids involving Canadian companies and even international companies. As in other economic sectors our neighbours to the south are our main partners in such transactions, particularly since each country's market depends on the other to a certain extent. New players, such as China, India and Russia, may be instrumental in influencing our transactional habits, especially in terms of the raw materials sector.

Amid this growth, new practices in the negotiation of mergers and acquisitions have appeared. Some of these transactions even prove to be mini sagas. Consequently, the emergence of a number of protection measures - mostly targeting initiators of takeover bids - has had the effect of deterring potential players interested in pursuing vigorous bidding while also stimulating bidding with a view to maximizing the company's ultimate sales value.

The Toys "R" Us case

In the summer of 2005, the Delaware Court of Chancery examined, among other things, these protection measures in its ruling in In re Toys "R" Us, Inc. Shareholder Litigation. This case was rooted in an attempt by certain institutional shareholders to block the sale of all Toys "R" Us shares in June 2005 to a group of private investors led by the firm Kohlberg Kravis Roberts (KKR) for a total of US$6.6 billion. The group of defiant shareholders contended that: (i) the negotiation of a termination fee equal to 3.75%, combined with (ii) a clause restricting the ability of the Toys "R" Us board of directors to accept a bid for a minimum of 50% of the company's shares, and (iii) a clause giving the group led by KKR the right to match any bid made by a third party, constituted "draconian" protection measures that would serve to eliminate any other potential bidders.

In a very detailed ruling, Vice Chancellor Strine rejected the shareholders' arguments one after another and reaffirmed the "business judgment rule," which states that a considered decision made by an informed board of directors, regardless of whether it is debatable from a strategic standpoint, should not be reviewed by a court of law if the decision is deemed to be reasonable. In this case, the Toys "R" Us board of directors was faced with a difficult situation. In the beginning, the company intended to put only its Global Toys division on the market, as this would generate sufficient liquidity to enable the company to keep its two other divisions including Babies "R" Us. After the company's financial advisors initially contacted 29 potential buyers and some of these buyers conducted preliminary due diligence - a process that took several months - the playing field was suddenly levelled to four players. Among these was Cerberus, which, contrary to predictions, made a bid for all Toys "R" Us shares evaluated at US$25.25 per share. At that point, the Toys "R" Us board was dancing to two different beats: promote the possible sale of the entire company without jeopardizing the option of selling only the division that was originally put on the market.

That is when the Toys "R" Us board decided to give the four bidders eight days to present a bid for the whole company. The board was certain that no other bidders would turn up based on studies indicating that no other potential buyers would come forward. Banding together with two of the other bidders (Bain Capital Partners and Vornado Realty Trust), KKR made a bid surpassing the one made by Cerberus by US$350 million, or US$1.50 per share, which is substantially higher than the value assigned to the company by the financial advisors - a value in the range of US$22 per share; however, this bid included the three protection measures listed above.

These measures included the termination fee, which consists of a fee paid to the bidder whose bid is voted down by the shareholders of the targeted company or who is eliminated as a result of a higher bid. The percentage associated with this fee is calculated based on the total value of the transaction. The initial bid made by the KKR-led group included a 4% termination fee, which was negotiated down to 3.75%, a percentage that is still above average for this type of transaction; therefore, if the bid made by KKR was not completed or was surpassed, it would receive US$247.5 million as compensation. This is the issue from which the case draws its potential to influence Canadian corporate law.

Some recent transactions

In Canada, termination fees are increasingly present in the transactional landscape. Case in point: the transaction through which Inco acquired Falconbridge. Inco's "friendly" take-over bid included a clause for a 3.5% termination fee, equivalent to US$350 million. In the transaction involving Barrick and Placerdome, an agreement was made under which Barrick would receive $259.7 million in compensation if the transaction was not completed.

More recently, in the deal that saw Arcelor SA go up against ThyssenKrupp AG to acquire Canadian steel giant Dofasco, Thyssen Krupp, which had been brought into the transaction by the Dofasco board as a "white knight," negotiated with the board to obtain a pre-emptive right entitling the German company to five days to match any superior bid made by Arcelor and to a payment of $215 million, or 4% of the transaction. The rest is history: Arcelor made a bid of $71 per share, a bid that Thyssen Krupp was unable to match or improve on, leaving the way open to Arcelor to acquire the Canadian company's shares. Dofasco was required to pay Thyssen Krupp the full amount, thereby depriving shareholders of $2.73 per share, an amount that reflects the difference between Thyssen Krupp's last bid and Arcelor's final bid.

Termination fees have taken on such importance that last November the National Post reported that even the Ontario Municipal Employees Retirement System (OMERS), an institutional stockholder of several public corporations, would oppose any termination fee greater than or equal to 2.5%. Some would criticize OMERS for taking such a position, but if we revisit the transaction involving Dofasco, there is no doubt that the shareholders would not have been able to obtain a bid as high as $71 per share from Arcelor were it not for Thyssen Krupp's involvement. Thyssen Krupp's presence had a leverage effect on Dofasco's shares; therefore, it is difficult to set a benchmark for analyzing an opportunity involving a termination fee.

Vice Chancellor Strine makes the very same affirmation in the Toys "R" Us case. According to him, determining the opportunity presented by a termination fee based on a specific test does not serve any purpose. He states that, although the courts of law should not turn a blind eye to excessive termination fees, it is impossible to affirm that a termination fee lower than a certain percentage, like 3%, would still be reasonable. For this reason, it is important to analyze the decision-making process followed by the board of directors. Vice Chancellor Strine also states that it is reasonable for boards of directors to consider a termination fee not only as a means of compensating a friendly ally for the costs related to a bid that is not completed, but also as compensation for a bidder who agrees, during the counteroffer period, to abstain from entering into any business opportunities due to the capital it puts on the table as part of these transactions.

The Canadian legal context

Canadian authorities had already issued a ruling on termination fees in 1998 in CW Shareholdings Inc. v. WIC Western International Communications Ltd.. In this case, where CanWest filed an oppression remedy application under section 241 of the Canada Business Corporations Act, CanWest sought to cease a trade bid made by Shaw Communications (Shaw) for all of WIC's shares in a move to have the court approve its own bid for the same shares. Among the reasons it cited, CanWest faulted WIC's board of directors for having signed an agreement with Shaw that included, among other things, a termination fee of $30 million. Justice Blair agreed with the notion that is widely held in the mergers and acquisitions market of granting a termination fee and specified that a termination fee is appropriate when (1) it is necessary in order to induce a competing bid to come forward, (2) that bid represents a better value for the shareholders, and (3) it represents a reasonable commercial balance between its potential negative effect as an auction inhibitor and its positive effect as an auction stimulator.

This is an application of what the courts call the "business judgment rule." In a nutshell, this rule holds that a court of law would be wary of substituting the decision of the directors or executives with its own, when a business decision was made on reasonable grounds, with sufficient information based on the counsel of the financial and legal advisors retained and appropriately consulted under the circumstances.

In Canada, this rule is all the more interesting because, unlike the American approach, the court places the onus of proving the unfairness of the transaction on the claimants; therefore, shareholders who do not want to see the deal completed (a situation involving a termination fee) would have to overturn the presumption of fairness.

Learnings from the Toys "R" Us case

In the Toys "R" Us case, Vice Chancellor Strine determined that, by lowering the termination fee from 3.75% to 2.5%, the resulting difference would only be about $0.33 per share. He stated that this difference would in no way deter a bidder prepared to offer substantially more than the bid of US$26.75 per share put forward by the group led by KKR. According to Vice Chancellor Strine, a company that is prepared to improve on a bid like the one made by KKR would be sufficiently motivated to absorb the termination fee. He also made a very interesting comment regarding the mergers and acquisitions market in the United States: "They [the players] are not like some of us were in high school. They have no problem with rejection." In this regard, he stated that, "The great takeover cases of the last quarter century - like Unocol, QVC and [-] Revlon - all involved bidders who were prepared, for financial advantage, to make hostile, unsolicited bids. Over the years, that willingness has not gone away."

Moreover, Vice Chancellor Strine contends that if the Toys "R" Us board had insisted on lowering the termination fee and eliminating KKR's matching rights, the board would have taken a closer look at the Cerberus bid and quickly realized that it was clearly higher.

Although Vice Chancellor Strine's comments may make him seem like a non-interventionist, he does recommend that, in the future, courts of law should determine acceptable parameters for the protection measures that are in use at a point when another ruling on these measures is required, but in a context that is different from the Toys "R" Us case.

In a situation where directors anticipate a number of class actions to be filed under bill 198, which came into effect on December 31, 2005 in Ontario, this ruling in Delaware, even in a M&A context, provides the directors and administrators of public corporations with some form of reassurance in that it once again confirms the application of the "business judgment rule." This decision will no doubt also be of great comfort to legal advisors involved in negotiating and drafting a protection measure of this kind.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Mr Nicolas Morin

Borden Ladner Gervais LLP

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