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In its 2003 Omnicare decision,[fn1]  the Delaware Supreme Court found that the directors of a target company violated their fiduciary duties when they approved a merger agreement under circumstances that virtually guaranteed stockholder approval of the agreement.  Stockholders holding a majority of shares had agreed with the buyer to vote to approve the agreement, and in the merger agreement the company agreed to hold a stockholders’ meeting even if the company board later withdrew support for the transaction.  The Court held that such a combination of mechanisms impermissibly limited the board’s ability to respond to subsequent events, such as a superior offer, and thus was unenforceable. 

Surprised by the decision, many commentators feared that it would limit the use of customary deal protection devices and make it more difficult for buyers and sellers to achieve certainty, thus potentially chilling the overall M&A market and lowering transaction valuations.  Looking back, however, it is apparent that Omnicare, while the cause of much anxiety, has had only an incremental effect on how transactions and deal protections are structured.  In fact, it is difficult to identify even one case where an Omnicare-driven provision resulted in an acquiror losing a transaction that was the subject of a definitive merger agreement.

Background

NCS Healthcare was a financially distressed pharmacy services provider that began to explore strategic alternatives.  NCS Healthcare attempted to negotiate a sale to Omnicare under a series of proposals, none of which would have resulted in recovery for holders of NCS Healthcare’s common stock.  These negotiations failed.

NCS Healthcare subsequently entered negotiations with Genesis Health Ventures, which proposed a transaction that provided full recovery to the debt holders and $1.00 per share to the common stockholders.  Omnicare then proposed a transaction pursuant to which the NCS Healthcare common stockholders would receive $3.00 per share.  NCS Healthcare used Omnicare’s proposal to negotiate better terms with Genesis.  But Genesis demanded that the merger agreement contain a "force-the-vote" provision which would require NCS Healthcare to submit the merger agreement to the stockholders for a vote, even if the NCS Healthcare board of directors no longer recommended the transaction.  Genesis also required two board members, who together owned a majority of NCS Healthcare’s outstanding stock, to agree to vote their shares in favor of the transaction.  After the Genesis/NCS Healthcare deal was announced, Omnicare launched a $3.50 per share tender offer for NCS Healthcare and brought suit in Delaware to invalidate the deal protections instituted by Genesis and NCS Healthcare.

The Delaware Supreme Court Decision

The Delaware Supreme Court held that the Genesis/NCS Healthcare deal protection measures should not be analyzed solely under the business judgment rule.  Instead, the Court subjected the measures to the enhanced scrutiny of the Unocal test, which requires a board to demonstrate that:  (i) there were reasonable grounds for believing that a danger to corporate policy and effectiveness existed, and (ii) the action to be taken was reasonable in relation to the threat posed.[fn2]  The Court concluded that the measures made it "mathematically impossible" for any other offer to succeed, even if more favorable to the stockholders, and that they thus failed to satisfy the "proportionality" prong of the test.  The decision made clear that when a merger agreement has both a force-the-vote provision and a voting agreement signed by the holders of a majority of the voting power, it must also include an effective "fiduciary out."

Anxiety Over Omnicare

The Omnicare dissent expressed concern that "attorneys counseling well-motivated, careful, and well-advised boards cannot be assured that their clients’ decision – sound at the time but later less economically beneficial because of post-decision, unforeseen events – will be respected by the courts…"  The Court’s decision also spurred alarmist rhetoric from commentators and practitioners about the far-reaching implications of the decision on the M&A landscape.  They feared that favoring corporate law fiduciary duty concerns over contract principles would increase uncertainty for M&A transactions in general.  The fallout from this increased uncertainty would be a potential reduction in the volume of M&A activity.  Others argued that Omnicare could cause some buyers not to put forth their best offer, for fear that subsequent superior offers would top them at the last minute, resulting in depressed M&A valuations.  Yet another concern was that the decision would increase the relative size of termination fees as initial acquirors attempted to protect themselves for the enhanced risk that they were being used as "stalking horses."

Analysis of Omnicare’s Real Impact

In the two years since Omnicare was decided, it has ended up having relatively little impact on the M&A landscape, in part because parties to M&A transactions have discovered ways to work within its constraints.  Examples of how parties have structured transactions in light of Omnicare are set forth below. 

The Quick Stockholder Vote and Stockholder Profit Provisions.  One technique is to arrange for stockholder approval to occur immediately following execution of the merger agreement.  In September 2004, BAE Systems North America Inc. entered into a merger agreement to acquire DigitalNet Holdings, Inc. for $600 million in cash (including assumption of debt).  The holders of approximately 59% of DigitalNet’s outstanding common stock entered into a stockholders’ agreement requiring them to immediately execute written consents approving the merger and satisfying the stockholder approval condition contained in the merger agreement.  However, the merger agreement also contained a 30-day fiduciary out provision which allowed the board (i) to recommend any alternative takeover proposal or determine that the merger is no longer advisable, if failure to do so would breach the board’s fiduciary duties, and (ii) to terminate the merger agreement if a superior competing bid materialized, regardless of whether the board would have a fiduciary duty to do so. 

The stockholders’ agreement also contained an "excess profits" provision.  This provision provides that if a superior competing bid is accepted by the target in accordance with the merger agreement, the stockholders are required to pay BAE Systems an additional termination fee of 65% of the difference between the BAE Systems bid and the superior bid.  While the excess profits provision is not required by Omnicare, it can be viewed as a reasonable acquiror reaction to the additional "stalking horse" risk created by the presence of the Omnicare-mandated fiduciary out provision.

On the same day the merger agreement and stockholders’ agreement were executed, the board approved the merger and written consents of the DigitalNet stockholders were obtained satisfying the stockholder approval condition contained in the merger agreement. While the transaction was not completely locked by Omnicare standards, it was rounding third and heading home on the day the merger agreement was executed.  With the excess profits provision in the stockholders’ agreement, any potential competing bidder was on notice that it would take a show-stopper competing bid to upset the BAE transaction.

Cutback Provision in Stockholder’s Agreement.  Another way parties to a merger can increase the certainty of a transaction while avoiding the reach of Omnicare is to include deal protections that terminate or become less restrictive if a competing bid materializes.  For example, in April 2005, PEC Solutions Inc. and Nortel Networks Corp. entered into a merger agreement, pursuant to which Nortel would acquire all of PEC Solutions’ outstanding common stock via a cash tender offer totaling $448 million.  The three founders of PEC Solutions, who together held 53% of the outstanding shares, entered into stockholder’s agreements with Nortel, binding them to tender their shares and to grant Nortel a proxy in favor of the transaction. 

The merger agreement also contained a no-shop provision, prohibiting PEC Solutions from seeking or even cooperating with another buyer, and a force-the-vote provision.  However, the force-the-vote provision allowed the board to withdraw its recommendation in the face of an unsolicited superior competing offer.  Furthermore, pursuant to the stockholder’s agreements, if the board withdrew its recommendation, the percentage of PEC Solutions’ shares that were locked- up would automatically drop down from 53% to 35%.  The automatic reduction in the number of shares locked-up caused the outcome of the tender to be less than a certainty in the event of a superior competing offer. 
This structure affords the acquiror a locked-up transaction unless there is a superior competing offer.  Even if there is a superior competing offer, the competing acquiror would have a steep hill to climb to obtain a majority vote of stockholders with 35% of the shares voting against the competing proposal and for the initial merger agreement.

Is Omnicare Limited to its Facts?

There is growing evidence that the Omnicare holding may be limited to the case’s rather peculiar facts.  Indeed, the only post-Omnicare decision addressing the validity of deal protection devices declined to extend the Omnicare decision.3  The Orman Court ruled that an 18-month lock-up agreement with the target’s controlling stockholder, which the buyer had required as a condition of the deal, did not "coerce" the other stockholders into approving the transaction and, therefore, granted defendant’s motion for summary judgment.  The Court rejected the plaintiff’s argument that Omnicare should reach to circumstances beyond a "fait accompli" of the type presented in Omnicare itself.  The Orman case suggests that Delaware courts may be reluctant to liberally apply Omnicare to other cases. 

In addition, Justice Joseph Walsh, whose vote was one of three comprising the Omnicare majority, has since retired.  The swing vote now rests in the hands of the recently sworn-in Justice and former Vice-Chancellor Jack Jacobs.  Nobody knows whether Justice Jacobs would support the Omnicare majority decision, but clearly the Omnicare majority is not as secure today as it was before Justice Walsh retired.

Conclusion

If Omnicare continues to be limited to its facts by future decisions, then the case will likely to continue to have little impact on the M&A landscape, since the deal protection devices employed were relatively extreme.  It is difficult to identify even one situation where an Omnicare-driven provision resulted in an acquiror losing a transaction that was the subject of a definitive merger agreement.  The predicted widespread gloom and doom on M&A markets from the decision has not occurred in the two years following the decision.  To the contrary, the M&A markets continue to flourish as creative and determined dealmakers find ways to make transactions work.